Portfolio manager Cale Smith’s riffs on investing, spoke funds, and Islamorada in the Florida Keys.

Among the most-needed changes currently under debate in the pending financial reform bill in Congress is an overhaul of the ratings agencies. These agencies get paid by the firms whose products they rate – a rather obvious conflict of interest that has nonetheless received indirect government support for many years. The high quality ratings bestowed upon the piles of financial garbage that eventually blew up and led to the recent credit crisis came from the Big Three rating agencies – Moody’s, S&P and Fitch – a cartel, if you will.

If you have any doubt about the need for reforming the credit rating agencies, and The Great Recession wasn’t evidence enough, I’d highly recommend Michael Lewis’ The Big Short
for some perspective. And after all we just went through, it’s hard to imagine anyone in charge of managing others’ wealth expressing any kind of support for perpetuating the current system.

But then there are the mutual funds. From an article in today’s WSJ (emphasis mine):

Making this tale even stranger than fiction, S&P has said it is ready to give up its special status. The political problem now is that the mutual fund industry is lobbying to maintain the cartel. Both regulators and fund managers have figured out that doing their own analysis to decide what constitutes an “investment-grade” bond is hard work. But if some third party (such as Moody’s) has deemed a bond safe, no one can second-guess the mutual fund for owning it.

To put a finer point on it, the raters give mutual funds a shield from lawsuits if their investments go sour. All the more so because the Senate and House reform bills contain provisions that will make it much easier for plaintiffs attorneys to sue the credit raters. As long as the cartel remains, everyone is covered—except the individual investor, who loses money when the cartel members rate the next Enron as highly as they rated the last one.

The irony is that it’s the individual investors in those funds who are helping to pay for the same lobbying efforts that end up screwing them over.

Sigh. Long live spoke funds.

Must-read article in yesterday’s WSJ:

The Hidden Costs of Mutual Funds

Portfolio managers can rack up steep expenses buying and selling securities, but that burden isn’t reflected in a fund’s standard expense ratio.

How much does it cost you to own a mutual fund? Probably a lot more than you think.

In selecting mutual funds, most investors know to check the expense ratio, the standard measure of how costly a fund is to own. U.S.-stock funds pay an average of 1.31% of assets each year to the portfolio manager and for other operating expenses, according to Morningstar Inc.

But that’s not the real bottom line. There are other costs, not reported in the expense ratio, related to the buying and selling of securities in the portfolio, and those expenses can make a fund two or three times as costly as advertised.

“These trading and transaction costs are very real,” says Stephen Horan, head of professional education content and private wealth at CFA Institute, a nonprofit association of investment professionals. “While it’s very important to look at that expense ratio, it’s just not going to capture” all of the costs, Mr. Horan says.

Read the entire article here. Morningstar’s estimates of the average fund expense ratio in the above is lower than the industry’s own estimates. I compare mutual fund costs to spoke fund costs here. And sign up here to receive my article “Ten Things You Must Know Before Investing in Mutual Funds.”

Presented without commentary.

Losing Mutual Funds Still Enjoy Big Paydays.
Despite 2008 decline, some fund giants garnered more than $300 million in fees

Many mutual-fund investors suffered heavy losses in 2008, but managers of some of the largest stock funds – including ones that fell roughly 40% in 2008 – gathered hundreds of millions of dollars in fees during that time.

And later on:

[Morningstar analyst] Dolan also suggested that the dollar amount brought in by fees be expressed in terms of total returns delivered by a fund. For example, if a fund’s returns in a year amounted to about $600 million, and it realized $300 million in management fees, investors would have a clear picture of how much fees affected returns.

The entire article is here.