Imagine you have lived your whole life in a region that is known for harsh winters, say, northern Minnesota. For the last four years, the winters have been extraordinarily mild. Despite knowing that winter is usually harsh, you’ve grown accustomed to mild winters and people are enjoying outdoor activities usually reserved for the summer months all year long.
You decide to take the plunge and buy a new car, which is a significant expenditure for you. Based on the great weather the last four years, you settle on a fun, rear-wheel drive convertible. In fact, the local car dealer is promoting the car as one that can be enjoyed year-round.
The following winter brings record cold and snow, the next winter is worse and the next winter is even worse. You spend the entire time skidding and cursing, happy to escape with your life and a few fender benders. You would love to just sell the car and move on, but you paid a premium when you bought it because everyone wanted one at the time. And the used-car market is flooded with fun, rear-wheel drive convertibles, driving prices even lower. You decide to just suffer and hang onto the car, hoping that the mild winters return.
Should the car maker be expected to make modifications to your car to handle winter weather? Or to only build cars that are both fun and rugged, even if they do neither well?
If the SEC dealt with cars, he might. The SEC is soliciting industry interest on whether mutual fund restrictions should be loosened on using borrowed money, selling stocks short on a bet the market will fall, and other tactics. These tactics are limited for most mutual funds, and are allowed only if specifically approved as part of the fund’s investment objective and practices. The SEC is concerned that after three years of losses, investors are looking to hedge funds, which have much greater flexibility in their investment practices.
There is nothing inherently wrong with these tactics, and there are plenty of options already for investors who want some protection in a down market: hedge funds, asset allocation funds that shift between stocks and bonds, and long/short funds that benefit from market declines. But the notion that all funds should have the ability to change their stripes with market conditions creates serious problems.
First, it creates an expectation that investors should not have losses in their funds but should still enjoy the gains of a favorable market. There will be even less interest in prudent asset allocation (which has been largely abandoned already) because each fund will theoretically be able to protect itself. The cold, hard truth is that all investments carry risks which must be accepted if the benefits are to be enjoyed. If the risks are too great, don’t make the investment.
Second, this notion nullifies two of the great advantages of traditional funds. A stock index fund is the best example of “relative predictability”, which simply means that we can’t know for sure where a market is going, but wherever it goes we know the index fund will follow. Likewise, “product purity”, or the assurance that a fund will always be invested in a particular part of the market, is essential to constructing and managing a diversified portfolio of funds.
Third, the more a fund changes, the more risk increases rather than decreases. Each time a fund manager uses these tactics he could be wrong as easily as he could be right. Investors won’t know what they’re buying and won’t be able to make timely decisions about their portfolios because they won’t know where the manager is headed.
The SEC is making other inquiries and has proposed other mutual fund changes that are worthwhile. Funds should have independent directors to protect shareholder interests, sales practices should be closely monitored and enforced, fund managers’ compensation should be dependent on long-term fund performance and “soft dollar” arrangements in which funds receive extra services in return for doing business with brokerage firms should be carefully scrutinized.
The SEC has overreacted to investor losses that were largely the result of poor portfolio diversification rather than a flaw in fund structure. If the SEC wants to protect investors, they should be issuing warnings about the inherent risks of hedge funds, encouraging asset allocation and tightening, rather than loosening, restrictions on mainstream mutual funds. If an investor wants a fund that changes its stripes, there are plenty available. But for investors to properly evaluate fund risks and manage their portfolio as their circumstances and market conditions change, funds must have a clear, specific objective and stick to it come hell or high water.