Portfolio manager Cale Smith on investing, Spoke Funds®, and Islamorada in the Florida Keys.

One of the advantages of working in the sweltering heat around Washington, D.C., when I was a bit younger was being surrounded by some truly impressive architecture. It’s everywhere – or at least it’s in enough places that you’ll at some point find yourself Googling things like “neo-palladian.” And you don’t need Tom Hanks with that bad haircut to tell you that the symbols built right into our capital’s buildings are amazing.

Walk around D.C. long enough and you’ll realize that many of those architectural symbols are repeated, and that one of the most frequently used is the fasces. In the literal sense, a fasces is a bundle of sticks bound together with an ax blade emerging from the center. In Roman symbology, however, a fasces stands for “strength through unity.” It’s also the root word in ‘fascism,’ but don’t hold that against those D.C. architects.

The most prominent place you’ve probably never noticed the fasces is actually at my favorite monument, the Lincoln Memorial. Look closely at the front of the arms of President Lincoln’s chair and you’ll see they are decorated with 10-foot-tall fasces.

In money management, I think the fasces perfectly represents a well-constructed portfolio. If you’re walking along Anne’s Beach here in Islamorada and come across a piece of driftwood, it’s usually pretty easy to break. Now put a dozen pieces of driftwood together, bind ‘em up with some line and then try to break the bundle. Not going to happen. That, I think, is the message behind the fasces symbol for investors – it gives them the power to withstand market downturns, unexpected company developments and economic shocks.

I try to build my Spoke Funds® at Islamorada Investment Management the same way. No matter how much time you put into researching a company, it’s just a fact that one of the businesses you own could develop a problem and, well, break. But if you take a handful of good companies and bind them together, even if one breaks, the bundle will hold up fine. And fortunately, as I mentioned earlier, your bundle doesn’t need hundreds of sticks. A dozen could do it.

There is one problem with my little metaphor here, though: don’t just go buy any stock that washes up on the beach. Try to learn as much as you can about value investing, and head inland to find the strongest sticks you can.

I’m a bit rough on the mutual fund industry, but this week, it seems appropriate to acknowledge one positive.

Mutual funds have democratized investments. Thank you.

Before the rise of mutual funds, if you wanted to invest in the stock market, you had to either be a big player or be prepared to get fleeced. When the market crashed in 1929 less than 1% of the public owned a share of stock. The first mutual fund began operations in 1928. It took a while for these funds to catch on, but now just about anyone with a 401(k), an IRA, or a 529 plan owns stocks indirectly through mutual funds.

Mutual funds brought investing to the people. That’s a good thing. They’ve allowed families to build wealth, educate their children, and retire securely, all without having to pay a personal money manager.

That said, the democratization of investing has at least one of the same issues as democratization of government. It’s summed up in a word that’s being used in Washington and on Wall Street a lot these days – transparency.

Just like in government, I think it’s only fair to know who is being given favors, and why. Why don’t mutual funds clearly identify their true costs to investors? Why do funds play favorites – putting big investors ahead of smaller ones? Why aren’t funds more forthcoming about how much of their managers’ money is invested in the fund? Why do investors have to pay big fees for closet indexers? And why are share classes so confusing?

Again, my hat is off to the mutual fund industry for popularizing stock ownership, but it has a long way to go. A lack of transparency is at least in part starting to cause investors to turn away. Is it really too much to let investors know at any time where exactly their money is invested, and why? And if not, what does that say about that industry’s attitude towards their customers?

I don’t believe Spoke Fund® firms have solved every ill of the mutual fund industry. But I do think there is a lot to be said for a transparent firm where investors know what the portfolio manager holds, why he holds it, how much it will cost for them to invest exactly the same way – and to have the assurance that each and every investor will be treated fairly, too.

I think that’s the least that investors should expect. Don’t you?

Happy Thanksgiving.

Keep this in mind whenever you’re considering where to invest:

The vast majority of mutual fund companies are much better at marketing than they are at investing. Most of the time, it’s not even close.
 
The primary way mutual fund companies grow is by attracting more dollars. So not only do they offer dozens or sometimes hundreds of funds, but they’ll cherry pick the best ones to highlight in glossy ads and television commercials to show as high a rate of return as possible. That’s because high returns are red meat for your average mutual fund investor.  

To get as high a rate of return as possible, it’s in the mutual fund companies’ interest to obscure as many costs as they can.

The laws are pretty specific about what costs a mutual fund can have investors pay, and which it must pay. Oddly, the oft-cited “mutual fund expense ratio” includes some expenses that investors shouldn’t have to pay, and excludes some that they do – though many investors may not realize it.

And this sort of muddying the waters can help those all too valuable 3-, 5-, and 10-year mutual fund return numbers be as high as possible.

So what numbers are hidden?  Trading commissions aren’t included in expense ratios, for one. Neither are sales loads, which, if you think about it, is particularly deceptive. And often marketing costs are hidden, too.

Many mutual fund investors, for instance, pay 12(b)-1 fees.  These are “marketing and promotion fees” that, in reality, are commissions paid to brokers who sell the funds.  

Now, let me ask:  If you are an investor in a fund, why should you pay for that fund to market and promote itself? Except in the la-la world that mutual funds inhabit, most people who pay for something want to receive something in return. The mere presence of these fees means you’re either paying for something and getting nothing in return…or you’re paying for someone to try to sell you something you already own. How much sense does that make?

Those nutty 12(b)-1 fees are currently being fought over by regulators and the investment industry.  The industry claims these fees are considered “continuing” compensation to the broker who sold the fund.  That’s understandable – as long as the broker has “continued” to service your account.  If not, that broker is literally getting paid while doing nothing.

If you have a brokerage account, you’ve also undoubtedly signed off on a lot of paperwork containing fine print. One of those things in very small font likely references “Revenue Sharing.” These are payments (does ‘kick-backs’ sound too harsh?) made by mutual fund companies to brokerage houses thanks to the old 12(b)-1 fee.

What the brokerage houses provide in return for their share of the revenue is beyond me – other than deliver unsuspecting investors to the funds, I mean. But what shouldn’t escape any of us is who is ultimately creating the revenue that a mutual fund company and the brokerage share:

Yep. The investors in the fund.

So not only might you unintentionally be paying your broker an upfront commission, but you may actually be paying him every month to sit there and do nothing. You could say he’s actually incentivized to do nothing, even. And you can see why, since it’s not at all uncommon to pay 75 basis points upfront and 25 basis points per month afterwards in just 12(b)-1 fees.

And how much of that will be disclosed to you upfront, in an easy to understand way?

I think you know the answer.

Ah, mutual funds. If only you used your powers for good instead of evil…