Sidestep the 'traps' many mutual funds set out

Gregory Baer and Gary Gensler are born raconteurs who love nothing better than a hearty laugh during a conversation.

Alas, the US mutual-fund industry won't find their new book very funny.

In "The Great Mutual Fund Trap: An Investment Recovery Plan," Mr. Baer and Mr. Gensler show how the average fund investor forks out inordinate fees and expenses, generally gets low returns for his or her endeavors, and – perhaps worse – tends to have a futile plan for long-range investment success.

And who benefits from the Baer/Gensler scenario? The large fund companies and brokerage houses that, taken as a whole, pull in $70 billion annually by imposing various charges on investors.

"We see ourselves as consumer advocates," says Gensler who, along with Baer, recently visited the Monitor's New York office during a promotional tour.

Unfortunately, Gensler says, "most investors are relying on experts to manage their investments." The truth is that in most cases, he says, the trust is misplaced, given the very nature of the financial-services industry, with its numerous fees and expenses, plus historical records of low returns.

Baer and Gensler, who held senior level positions in the US Treasury Department during the Clinton administration, hope to provide investors with the tools needed to improve their investment results.

Most important, says Baer, is that fund investors need to see that there are actually ways of making money in mutual funds over time. Yes, that's right – making money.

Investors, says Baer, need an asset-allocation plan that meets their specific long-range needs. (Asset allocation is the mix of stocks, bonds, and cash holdings best suited to a person's financial goals.)

Far too many investors have no plan, he says, or fail to stay with a long-range plan.

"Then look for ways of lowering costs," says Baer, such as using low-fee index funds, which invest in broad market indexes such as the Standard & Poor's 500 index. And "cut out the middleman" as much as possible in financial transactions. If you need to consult an investment adviser, for example, use a fee-only financial planner, he says. Look out for hidden commissions on products. In most cases, do your investing yourself through a no-load fund company or over the Internet, using low-cost or discount brokerages.

Americans react angrily to the $1.50 ATM surcharges they pay, on average, 50 times per year for a total of $75, the authors point out in their book, yet don't seem to notice a 5 percent sales load a $10,000 mutual fund investment that costs an investor $500.

If you buy government bond products, then buy them directly from the US Treasury, Baer says.

Also consider buying exchange traded funds (ETFs), which work like index funds but are more tax efficient and have lower fees, he says. To purchase them, you will need to go through a broker.

If you are setting money aside for college, "look for college savings plans, known as 529 plans," says Gensler. They let you invest your education dollars over time, in stocks and bonds, and they do so tax-free so long as the money is used for college education. Gensler and Baer's choice: the Utah 529 plan, which uses the low-fee Vanguard Group to manage its plan. (See www.uesp.org.)

"You don't have to live in Utah to invest in their plan," Gensler says. You don't have to spend it there, either.

In addition, if you watch news broadcasts on investments or the stock market, do so only "for entertainment purposes," says Gensler. Don't get caught up in the drama of the market, he says, buying or selling based on day-to-day market news. Instead, he says investors should avoid day trading and look for long-term performance.

Gensler and Baer are particularly critical of managed mutual funds, in which Americans currently have some $3 trillion invested, primarily through 401(k) plans. The average actively managed fund underperforms the stock market three out of every five years, they say. Through 2001, for example, the 1,226 actively managed stock funds with five-year track records trailed the S&P 500 index by just a tad under 2 percent per year. In fact, over the period 1991-2000, only one fund, the Legg Mason Value Trust managed by veteran fund manager Bill Miller, outperformed the S&P 500 every year.

Gensler and Baer see that outperformance as "random chance," a view that, of course, would not be accepted by most Legg Mason investors – or, presumably, Mr. Miller.

Gensler and Baer, of course, are index-fund enthusiasts. In looking for an index fund, you should look for a total market fund with at least as much coverage of the market as the S&P 500, they say. Then, look for low fees and a no-load administrative structure. Both Vanguard and Fidelity, they note, offer solid index-fund products.