John Spence

Interview with Mutual Fund Gadfly, Roy Weitz, of FundAlarm.com

Roy Weitz, CPA is the founder of FundAlarm.com, an independent and noncommercial website that serves as an unofficial community watchdog for the mutual fund industry. Mr. Weitz writes a revealing and colorful monthly commentary on the industry that is eagerly anticipated by mutual fund junkies. The site also hosts a lively discussion board and keeps updated lists of mutual funds that should ring alarm bells if they're in your portfolio.

Q: How long as FundAlarm.com been around? What was the motivation for starting the site, and what do you hope to accomplish through the site?

A: I started it in July of 1996. I wish I could say that my motivation was purely altruistic, but I really started it to get more hands-on experience using what was then the new medium of the Web. I wanted to do something that would keep me interested and might have potential to go somewhere, and somehow I came up with FundAlarm. It's a site to help investors decide when to sell mutual funds, which was something that didn't exist at the time on the Web or in print. So it really started as a personal project that has taken on a life of its own.

The site is fairly well read, and it's got a particularly good following among financial journalists. I think that's probably my best avenue of influence - to the extent that writers read the site, pick up ideas, and expose them to a broader audience. That's positive, and that's really the best way for me to have real influence.

I am read by the industry to a lesser degree. I know that people at some of the big fund companies do wait for the monthly commentaries. And just maybe some of them wonder before they do something if it's going to appear in FundAlarm.com, and maybe they won't do it. [Laughs] That may or may not happen - it probably doesn't, but it is nice to think about that sometimes.

Sometimes we'll cover something in the fund industry on the site and a little later the problem is dealt with. Maybe the SEC would have be fixed the problem anyway without my commentary, but little things like that are at least encouraging.

Q: What's your take on mutual fund portfolio disclosure? How often should funds disclose holdings, and with how much lag time?

A: Simply, portfolio disclosure is essential, and it's not being done enough. Ideally, funds would disclose once a month with perhaps a three-month lag. Realistically, probably quarterly with a three-month lag would be an improvement. That would be real progress, and I think it's going to happen. I really do. Part of it is the pressure of the media and the ink this issue receives, otherwise I don't think this would have happened.

Q: Is the resistance to disclosure uniform across the fund industry?

A: No, I think the larger the fund companies are more sensitive about this. The Investment Company Institute (ICI) is opposed to it I think on general principle, and also because the larger fund companies are against it. The larger fund shops are opposed to disclosure obviously because they're more concerned about front running.

I think there's also just a general opposition because they don't want to be told what to do. To them, it's letting the camel's nose under the tent. If this type of disclosure becomes a rule, where will it end? So they draw the line here.

To me, if there's a fund that's hurt by front running when it discloses three months after the fact, then really . . . they deserve to be hurt by front running. That's just ridiculous. What this means is they have such a huge position that they can't unwind it in three months. Or they're still working on something three months after they started it. If you think about the funds that will be affected by disclosure, they're probably the huge bloated ones. Maybe this will be an indirect way to get some of those funds to trim down their positions a bit. Because they shouldn't have positions that could possibly be affected by front running if there's a three-month lag on disclosure, unless I'm missing something.

Regarding the small fund companies, disclosure is going to be a little of an administrative burden. But small funds don't have large enough positions to be affected by front running, so that's not an issue in my opinion.

Disclosure can be done cheaply and easily via the Web. If a mutual fund is not keeping track of its portfolio on a computer now, then it's got a serious problem! The technology is there today to make disclosure a relatively easy task.

Q: The SEC has been talking about taking a look at mutual fund 12-b1 fees. What was the original function of 12-b1 fees?

A: As I understand it, the original purpose of the fee was to spread the marketing costs for a fund over the entire shareholder base. The goal is to get the assets under management larger so that overall costs could come down with economies of scale. But talk about something taking on a life of its own. I think the 12-b1 fee has mutated into some monster that was never really anticipated. To me, the fees are clearly not being used for what they were originally intended for.

Will the SEC take action? I don't think so. But this issue is potentially where the rubber hits the road for the SEC. If they take action on 12-b1 fees, then you know they're serious about mutual fund regulation.

The whole structure of the fund industry is really dependent on 12-b1 fees now, so I can't even imagine the squawking there would be if the SEC considered restricting 12-b1 fees.

Q: What's the most important challenge facing the mutual fund industry today?

A: Competence. Simply, the talent pool in the mutual fund industry is so diluted, and the number of offerings is so vast. The results are generally so poor that I think people are losing faith in the competence of the mutual fund industry. In order to prosper, the fund industry needs to show it can pick stocks - that it knows when to buy stocks, and when to sell stocks. Ultimately, fund managers need to show that they can produce performance that beats the unmanaged indexes. Until they do that, they really have no reason to exist.

Q: FundAlarm.com keeps a list of funds to avoid. What criteria do you look at when compiling those lists?

A: It's quite mechanical. Basically, I put every fund into a benchmark category. There are five main categories - large-cap, mid-cap, small-cap, balanced, and international. Then there are six specialty categories. I compare every fund to its benchmark, and in my lists each benchmark is an actual fund, rather than an index. For example, large-cap funds are benchmarked to the Vanguard 500 index fund; the mid-cap funds are compared to the Dreyfus Mid-Cap Index because Vanguard didn't have a mid-cap fund when I started this. Small-cap funds are up against Vanguard's small-cap index fund tied to the S&P SmallCap 600.

International funds are up against the Schwab International index fund because again Vanguard didn't have one at the time. Balanced funds are benchmarked to Vanguard's Balanced Index.

If a fund has trailed its respective benchmark for the last year, three years, and five years, then it goes on what I call my three-alarm list. There's a lot of misunderstanding concerning the three-alarm lists, and part of it my fault, and part of it is that people are looking for easy answers. The three-alarm list is not a recommended sell list or automatic sell list. Basically it's designed to tell people that if your fund is on the list, then at least take a good look at it and see why.

I liken the list to the tired old analogy of the smoke detector. If it goes off, your house could be on fire. But it could also be cobwebs in the smoke detector, in which case you just change the batteries and go back to sleep.

The list just signals that people should take a look at these funds if they own them. It doesn't mean you should sell the fund, but you want to examine why the fund is underperforming. For example, when growth was hot in the 1990s, value funds compared against the S&P 500 index didn't do that well. A lot of those value funds ended up on the three-alarm lists, even if they were performing well against other similar value funds. So in that case it makes sense to hold it even though the fund made the three-alarm list. And you always want to take into account the tax consequences of selling a fund.

The criteria are very simple, and I think people like the simplicity because it gives them a clear answer. But it's not the only answer, and people need to take a closer look beyond the list.

Q: What's your take on the counterproductive mutual fund asset flows in the industry? Why do investors buy high and sell low?

A: This is an area where the mutual fund industry is not entirely to blame. Mutual fund companies have products and naturally they're going to push their products. When they advertise fund performance, I think they do have to do a better job of putting that performance in perspective. Certainly that contributes to the "buy high" phenomenon.

But mutual fund investing involves a certain amount of psychology, and unfortunately it seems that we're hardwired to make these mistakes - it's human nature. Perhaps the problem stems from the way we shop for most items in our consumer lives. If you're going to buy for example a stereo, you look at Consumer Reports to see who has the highest ratings. You can look at Morningstar or other fund trackers to find the hottest mutual fund. Maybe the way we're conditioned to shop predisposes us to make bad decisions in investing. We buy the fund with the best recent performance, just like the way we buy the stereo with the best up-to-date ratings.

So maybe we can blame our parents [laughs]. We're shopping the way they told us to; only it just doesn't seem to work for mutual funds.