"Investor's Manifesto:" Chapter 5


Continuing my chapter-by-chapter notes on William Bernstein's "Investor's Manifesto," here we take up Chapter 5.

I'll open with a quote from Bernstein that nicely summarizes the chapter:

The prudent investor treats almost the entirety of the financial industrial landscape as an urban combat zone. This means any stock broker or full-service brokerage firm, any newsletter, any advisor who purchases individual securities, any hedge fund. Most mutual fund companies spew more toxic waste into the investment environment than a third-world refinery. Most financial advisors cannot invest their way out a paper bag. Who can you trust? Almost no one.


Stock Brokers and Brokerages

Bernstein explains why the landscape is so gloomy:

There are no educational requirements on brokers or financial advisers, or the managers of hedge, pension, or mutual funds. Bernstein says, "I have yet to meet a brokerage representative, for example, who has heard of Fama and French, knows the history of the securities markets in any detail, or can easily describe how risk levels affect investment returns over time."

People generally do not go into the financial services industry because they are public spirited and wish to help others. (With prominent exceptions such as John Bogle.) People get into the financial services industry to make money. And they make their money from you.

Conflict of interest. With the exception of Vanguard, which is owned by its investors, a mutual fund has two masters -- their clients, who invest money in the mutual fund, and the shareholders in the brokerage or fund company itself. In practice they end up serving the owners of their companies at the expense of their clients. Bernstein says, "the company’s primary goal is to bleed its clients as copiously as possible to feed its shareholders and management."

Bernstein illustrates this with an old anecdote: "One hoary investment company story describes a young broker asking an old one about the secret to his success. The latter replies, 'It’s simple; over the years I’ve slowly transferred my client’s assets to my own name.'"

Brokerage employees are trained extensively in sales, and receive minimal training in actual investing and finance.

Federal and state law do not regulate brokers in the same way they regulate doctors, lawyers, and for that matter, hairdressers. Brokers are not fiduciaries, meaning they do not have a legal duty to put their clients interests first. Bernstein again: "Accountants, lawyers, bankers, and doctors all have fiduciary responsibility to clients and patients, as do investment advisors. Somehow, the brokerage industry dodged this bullet."

Bernstein concludes this section by advising us not to go anywhere near a stock broker or a brokerage firm.

Mutual Funds

Bernstein likes mutual funds better, not because fund managers are less rapacious, but because it's more transparent and the Investment Company Act of 1940 gives small investors a fighting chance.

Mutual funds are diversified. We've covered the reasons for diversification previously.

Mutual funds publish their fees and expenses. When you buy through a brokerage, you don't get that kind of visibility.

While your broker might be a high-school dropout, your fund manager likely has an advanced degree in finance or economics. This doesn't allow a fund manager to beat the market regularly, but mostly does keep them from making the same really dumb mistakes that brokers make.

The Investment Company Act of 1940 provides you protection against theft. Outright fraud is very rare with mutual funds.

Now, on to the problems with standard, actively-managed mutual funds:

The same conflict of interest strikes mutual fund managers -- they owe their loyalty to their employers, the stockholders of their company. Their goal is to maximize the amount of money in their fund, because their pay is a percentage of the amount managed. Their goal is to have good returns for the fund only so far as that gets people to invest.

This naturally leads to the advice Bernstein highlights: "Do not invest with any mutual fund family that is owned by a publicly traded parent company."

Only one mutual fund company is owned by its own funds, and thus by the mutual fund investors -- Vanguard. Thus the strong preference for Vanguard many times in this book.

The next-lower run of mutual fund companies in terms of desirability is privately-held companies, including Fidelity Investments, Dimensional Fund Advisors, and American Funds. "The key point about these companies is that their shares do not trade publicly, and thus they do not have to publicly report their earnings every quarter. While these for-profit entities are certainly not immune to agency conflict, they tend to have a longer-term focus that benefits their customers, the shareholders of their mutual funds."

Fidelity is a marketing-oriented company with a large number of funds you should ignore, but they have a set of low-cost index funds that operate as loss leaders to get you in the door. Stick to the loss leaders.

American Funds group has probably the best-managed active funds. They're still actively managed, with all that entails. Avoid them.

Dimensional Fund Advisors, run on the principles of Fama and French, has a strong collection of passively-managed funds. You must pay an advisor to gain access to DFA's funds, and in Bernstein's view, DFA is not worth the additional advisor fee and their slightly higher-than-Vanguard fee structure.

I'll print Bernstein's summary in its entirety:

You are engaged in a life-and-death struggle with the financial services industry. Every dollar in fees, expenses, and spreads you pay them comes directly out of your pocket. If you act on the assumption that every broker, insurance salesman, mutual fund salesperson, and financial advisor you encounter is a hardened criminal, you will do just fine.

Both mutual fund companies and brokerage houses know more ways than you can count of fleecing you without your knowing it.

Invest, if you can, only with nonprofit mutual fund companies. If you must work with profit-making entities, they should be privately owned. If forced to work with a financial services company that belongs to a publicly traded parent, buy only those products that come with the lowest expenses and turnover; this usually means exchange-traded funds.