Sunny Sarkar

How to become an investment legend

The dirty secrets of the mutual fund industry

Step 1: Incubator funds
Let's start a mutual fund company today with four new funds (assume $10m assets in each) wisely invested in four different sectors of the market. We do this because we know that market sectors are essentially on a random walk, and that there is no way to predict which market sector will do best in the next few years.

Wise as we are, we quietly keep doing our job for three or four years, after which, as we had expected, one of those four funds, out of sheer randomness, beat the market handsomely because the sector it was invested in just had a few good years. Another one of our funds, the one that most closely resembles the market, did just what the market did (of course); and the other two did miserably because their sectors didn't do well.

Step 2: Hide the losers
Now we "merge" the bad fund and the average fund into the best fund "keeping the best interests of our investors in mind", i.e. we take all the money left in the two worst performing funds and convert them into shares of our best performing fund. This way we simply kill off the bad performers and hide them forever so that nobody comes to know about it. This genius trick is called "survivorship bias", but shhh... don't tell anybody.

Step 3: Let the genius be known to the public
Now is the time to let the world know about the genius that we are. We aggressively advertise the performance of our best fund - full pages on financial magazines loudly display their market beating returns over the last few years. The internet financial websites and blogs start buzzing. We land an interview or two on CNBC where we claim that the stocks in which our best fund was invested over the last few years were "poised for growth", and we express our astonishment over how other investment professionals failed to see the obvious market signals that seemed like common sense to us. More and more investors come to know about our great new fund company, now being dubbed "wall street's best kept secret", which has only two funds - one of which "most definitely" demonstrates our supernatural powers of picking the winners in advance, and the other fund is there just for the wimps who don't like risky investing. At this point, as predicted, performance chasers take note and jump in. Money starts flowing in and assets in our "best fund" bloats to, say, $2 Billion, growing daily.

Step 4: Retain the advantage
We are now well on our way to become investment legends. We have correctly figured out that since our best fund has already beaten the benchmark (a market index like the S&P 500) in its first few years, all we have to do now is to track the index closely so that we forever retain that initial advantage versus the index. We become the so called "closet indexers", i.e. we buy stocks very closely resembling the makeup of the index (but of course we deny that in public).

And so the years pass. Our closet indexing strategy guarantees that, given our lead from the initial years, the annualized or cumulative returns of our "best fund" will always look better than the index for the last 1, 3, 5, 10, or "since inception" years (time-weighted returns).

Step 5: Keep quiet about the dirty secrets
The only investors to have benefited from our strategy are those lucky ones who had invested the first $10M in our best fund. All the subsequent dollars that came into the fund have tracked the index at best (because we were "closet indexing"), and almost certainly underperformed the index after expenses (net investors' return = gross index return - investment expenses). If you measure the returns that each dollar has earned since it was invested in our fund (dollar-weighted returns), since most of them came in after our period of out-performance, it is dramatically different and inferior from our much touted "annualized returns" and "cumulative returns". All this really means that our investors have done really poorly while we were busy becoming investment legends - but of course we are not telling that to anybody.

There's more... In order to pretend that we were doing something other than closet indexing, we have bought and sold a lot of stocks now and then, while cleverly keeping the overall composition close to the benchmark. Our investors have paid for this portfolio churning in the form of brokerage transaction fees, bid/ask spreads, and the biggest cost of them all - capital gains taxes!

But we're not telling that to anybody either.

Meanwhile we appear frequently on financial magazine covers, finance columnists on the web rave about us, books/articles are written about our winning stock picking strategies, and we are rich. Our investors think they have "seen the light", and some of them discuss our annualized/cumulative returns triumphantly every month on internet forums in order to demonstrate how smart they have been to have invested with us. Only one obscure cult-ish forum in one corner of the internet manages to figure out what really happened - but they were not the target audience of this drama anyway.

Step 6: Quit while you're ahead
But all those extra transaction fees, spreads, and higher taxes are gradually eating into the advantage we had in our best fund versus the benchmark index. If it gets too close, we'll lose our "legend" status. It's time to seal the deal now. Retire! Let the managers who replace us take the blame. We remain rich, famous, and basking in the glory of our "success" - forever and ever and ever.

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