By Ronald
L. DeLegge, Editor of ETFguide.com - April 4, 2007
The virtues
of asset allocation are being erased every single day by the insidious behavior
of Wall Street's largest money managers. Are you a victim?
For example, certain mutual funds with billions
under their supervision purport to be
actively managed, but their performance and risk metrics so closely ape
corresponding indexes there's hardly a difference! Who in their right mind
would pay higher expenses to own an imposter when real index funds can be had
for a fraction of the price? The world's best asset mix cannot overcome the
negative impact of closet index funds that rob performance by overcharging.
What about style drift?
This happens when a money manager deviates from a fund's
investment objective to pursue another course. It's like breaking the rules in
the middle of the game.
And it's a quite frequent occurrence too.
It's not uncommon to find so-called value funds owning growth
stocks and vice versa. In
fact, style drift is so dangerous it's even perverted fund classifications.
Mutual funds erroneously categorized as domestic funds often
have significant holdings in foreign securities. How could it be?
But wait, it gets worse.
World class money managers are
succumbing to the style drift disease.
Some years ago, Bill Miller the
famed manager of the much heralded Legg Mason Value Trust raised eyebrows by
investing in Amazon.com. When besides never has Amazon ever been a true value
stock? And how many active mutual funds have phantom outperformance because
they've been style drifting themselves to the top? For investors, it's a
conundrum. Precise asset allocation is near impossible.
Then too, there's superficial window dressing.
A 2004 academic study* produced by Northwestern
University revealed widespread problems for more than 4,000 U.S. mutual funds.
More times than not, the last trading day of each
quarter is the busiest. Why? It's largely because of window dressing. In other
words, portfolio managers try to make themselves look smart by selling their
losers and replacing them with securities that probably performed better. This
gives the false impression the fund owned the good performers, when in reality
it didn't. Such behavior is damaging to asset allocation and subjects a
portfolio to high turnover and needless trading activity.
In each of these destructive examples, asset
allocation is powerless.
Is it any wonder exchange-traded funds (ETFs) have emerged
as such popular and powerful financial tools? Like their traditional index fund
relatives, they completely eliminate the detrimental impact of mutual funds that
closet index, style drift, and window dress. It's good news to know that precise
and undisturbed asset allocation does work with ETFs.
On the other hand, asset allocation with anything
else is a big question mark.
*"Do Funds Window Dress? Evidence for U.S. Domestic
Equity Mutual Funds", by Iwan Meier and Ernst Schaumburg from Kellogg School of
Management, Northwestern University in August 2004
