More than 70% of funds under-perform their benchmark every year. It's pathetic.
On average, an actively-managed fund returns 2% less (after fees) than the index it's measured against. A $100,000 portfolio that compounds 10% per year will grow to $1.7 million in 30 years. The fund with a 2% drag? Just $1 million. That's a $700,000 difference.
For starters, the compensation structure is flawed. Mutual fund managers get a slice of your investment (typically 1%-2%) every year, no matter how they perform. Because they're paid based on total assets under management, not performance, managers shift focus from returns to fundraising.
More important, mutual fund regulations meant to protect investors actually make matters worse. For example, some rules mandate diversification. So instead of owning his 10 favorite stocks, a mutual fund manager may be forced to own more than 100 stocks – and dilute returns in the process.
Rules can also force managers to sell winning stocks prematurely, as their increased presence in the portfolio violates the diversification mandate. Also, size rules prohibit large-cap mutual funds from owning mid- or small-cap stocks, even if it's the best thing to do at the time.
Other rules prevent funds from buying companies in the midst of corporate restructuring or those temporarily losing money, or owning a stock that trades too few shares a day, or shorting stocks.
I could keep beating up on mutual funds. But my point is our hands aren't tied. And we can take full advantage of the mutual fund industry's cumbersome rules and poor performance. Burdened by heavy government regulation, clumsy mutual funds create lucrative market "glitches" for smart investors.
One of the most successful investors to recognize and take advantage of these loopholes is Joel Greenblatt. Greenblatt's hedge fund – Gotham Capital – generated 50% profits every year for a decade. Every dollar invested in Gotham back in 1985 turned into $52 when Greenblatt closed shop and returned all the money in 1994.
Greenblatt outlined his killer strategies in his top-selling book You Can Be a Stock Market Genius. His focus is "special situation" investing. In short, he buys stocks undergoing some sort of corporate reorganization – spinoffs, mergers, acquisitions, and bankruptcy restructuring. In other words, an event that creates massive price fluctuations – and prevents mutual funds from owning shares.
If you're interested in special-situation investing, I recommend starting with Greenblatt's excellent book. Then, take a hard look at Canadian-based biotech company QLT (NASDAQ: QLTI; TSX: T.QLT).
Faced with steep competition for its flagship drug for eye disorders, QLT decided to liquidate all its non-core assets starting in 2008. But mutual funds holding the stock couldn't wait any longer. They had watched QLT shares drop from over $20 (in 2004) to below $5, a loss of 75%. Many were forced by their charters to dump their stock.
I figure about 90% of QLT's shares were held by growth and health-care funds. When those investors sold out, the ensuing liquidation pushed QLT shares to $2. That's about 15% below QLT's net cash. But like I said, mutual funds are terrible investors.
QLT is in the best shape of its life. The company receives royalties from two marketed drugs, sold by European pharmas Sanofi-Aventis and Novartis. And the newly-restructured company turned profitable again this year. With the mutual funds forced out of the shares, it's a perfect Greenblatt setup.
My FDA Report readers are up a couple points on the stock already. I expect we'll double our money before the end of the year.
Read more Stockhouse articles by Dr. George Huang