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Lindley Estes is a business writer for The Free Lance-Star and This blog is on Fredericksburg-area business. Send an e-mail to Lindley Estes.

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New book skewers the mutual fund industry

"There is something rotten in the mutual fund industry."

Thus begins "The Investor’s Dilemma," a new book by Louis Lowenstein that paints a highly critical picture of the way mutual funds operate.

Lowenstein is a professor emeritus at Colum-bia Law School who writes on financial markets. While skewering the industry in general, Lowenstein also gives guidance as to what funds stand out above the crowd.

Lowenstein’s critique is primarily aimed at the large mutual fund management companies, which he says focus more on marketing products to investors rather than successfully investing their clients’ money.

The fund management industry is a big and highly profitable business, one that has more than $10 trillion in assets and stunning profit margins. The companies that provide the services are paid based on how much money they have under management rather than how well they perform.

Funds are therefore constantly created, and losing funds are simply folded into newer offerings. The management companies charge their investors money for mar-keting expenses, even though asset bloat leads to poorer performance.

Brokerage firms are paid generously to recommend the fund company’s products to their customers, even if the funds themselves have been average at best.

Fund managers flip through stock holdings depending on which sectors are hot, leaving the investor with hefty tax bills and diminished per-formance. Many funds mimic or underperform index funds, which cost investors far less.

These are just a few of the critiques Lowenstein makes. He also points a critical finger at the Securities and Exchange Commission, which he says doesn’t require enough disclosures from the funds. Investors, many of whom chase what’s hot, also aren’t spared.

Despite the criticism, Lowenstein maintains that a select group of mutual funds are still the best way to go for the majority of investors who lack the time or ability to pick individual stocks.

Many people suggest that such "know-nothing" investors simply buy low-cost index funds that mimic the overall stock market’s return. But Lowenstein says index funds are problematic if purchased during times of market euphoria.

Instead, he advises, pick value-oriented mutual funds that have demonstrated a commitment to being shareholder-friendly and that have managers who can guide their investors through the market’s ups and downs.

Lowenstein advises investors to look for the following qualities:

  • Funds that buy a small number of carefully researched stocks and hold them for years. Although most preach the value of diversifi-cation, Lowenstein believes it makes more sense to bet big on companies that stand out as undervalued and honestly managed.
  • Funds in which managers "eat their own cooking" by investing their own money in the fund.
  • Funds that choose stocks on the principles of value investing laid out by Benjamin Graham and followed by Warren Buffett. These funds are willing to go against prevailing opinions (an attribute many preach but few execute).
  • Funds that are willing to hold cash when they see few opportunities and close to new investors when it seems having more assets would detract from performance.
  • Funds that have excelled not just in the past quarter or year, but in the past decade or more. The market crash of 2000-02, ensuing boom and recent pullback provides a nice testing ground for how funds have done in several differing market conditions.
  • Funds that have a proven manager who communicates honestly with shareholders. Low-enstein says many of the bigger fund companies pay little mind to selecting managers, treating them like commodities.

Lowenstein wraps up the book by recommending two specific funds that he says possess these attributes: Fair-holme and Wintergreen.

As Lowenstein points out, more than 90 million individuals own mutual funds, whether directly or indirectly through retirement plans. With corporate pensions being cut and Social Security funding up in the air, mutual funds are a critical piece of many people having a comfortable retirement.

Thus, most would be well-advised to learn about mutual funds. "The Investor’s Dilemma" is a good start.

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