Despite recent gains in stocks, mutual funds have far to go

The average stock fund has gained 17% the past three months and 6.5% this year — handily outstripping the Standard & Poor's 500-stock index. Aside from the stock market's recent upturn, though, investors don't have many reasons to rejoice.

Even counting the most recent stock rally, fund investors have seen 37% of their savings disappear since the market peak in October 2007.

"I am very displeased with the management of the funds that I owned," says Robert Wells of Largo, Fla. "The fund managers are advertised as being professionals, so why did they ride the market all the way to the bottom with my money?"

The fund industry can't control the stock market, but the criticisms leveled against the industry before the bear market are still true today: The funds still command high fees for their services; the industry pumps out new, faddish funds at a frenetic pace; and scandals plague the industry.

"The industry has not done the individual investor a lot of favors," says Dan Wiener publisher of The Independent Adviser for Vanguard Investors.

Catching a break?

Long-suffering stock-fund investors caught a break this quarter, as funds scored the first winning quarter in a year, according to Lipper, which tracks the funds. And a few types of funds, mainly emerging-markets funds, scored enormous gains:

•Latin America funds, up 44.2% this year.

•China funds, up 37.4%.

•International small/midcap funds, up 21%.

This year's top fund, the tiny Oceanstone fund, soared 128%. And Fidelity Select Auto, one of the most surprising leaders for the year, roared ahead 56.5%, in part by avoiding General Motors.

All those gains are great for the few investors who were in them. The largest stock funds, which are most likely to be in a 401(k) plan, scored more modest — but still welcome — gains so far this year (see chart, 4B).

Nevertheless, those gains pale in the face of the enormous losses investors have endured for nearly a decade. Had you put $100 a month into the American Funds Growth Fund of America for a decade, for example, you'd have $12,124 today. But you would have invested $12,000, so your gain for the entire period would have been just $124 — and that's not counting the fund's sales charges, which can be as high as 5.25%.

The Growth Fund of America sports one of the better records among big funds. The same investment in Fidelity Magellan would be worth $9,712, and Vanguard 500 Stock Index fund would be worth $10,377. So it's no surprise that many investors who have staked their retirement on the stock funds in their 401(k)s aren't happy.

"My funds have done poorly," says Donna Hogan of Coralville, Iowa. "Are there any funds that need praise right now? No."

Stock mutual funds, however, are generally required to stay mainly invested in stocks, and many funds survived the market tolerably well, says Russel Kinnel, director of mutual fund research for Morningstar. "Fund companies communicated what was going on pretty well," Kinnel says.

And, Kinnel says, some investors shifted heavily into value funds after the 2000-02 bear market. Value funds look for stocks whose prices are low, relative to earnings, and had held up well when technology stocks melted down. Unfortunately for value funds, financial-services stocks often pop up on lists of relatively cheap stocks. So big value funds, such as Legg Mason Value Trust, got slammed in the most recent bear market. "Those who made big shifts hurt themselves," Kinnel says.

A good business

One industry that made money last year — and good money at that — was the mutual fund industry. Although fund-company earnings weren't as good as in a bull market, running the biggest funds remains a highly lucrative business. A fund that grows from $1 billion in assets to $10 billion in assets doesn't see a tenfold increase in expenses. Economies of scale mean that big funds are cash machines.

Last year, for example, the 25 largest stock funds pulled in nearly $7 billion in fees, according to estimates by Lipper. Of that $7 billion, about $4 billion, or an average $168 million per fund, went to management fees. Fund-management companies, like all other companies, have expenses people might not think of — nurturing smaller start-up funds, for example. Nevertheless, "The fund business is still a very good business," says Michael Lipper, president of Lipper Advisory Services.

The Investment Company Institute, the funds' trade group, points out that expense ratios have dropped 50% in every fund category since 1980, to an average 0.99 percentage points per investor. On the other hand, the industry's assets have grown to $10 trillion from $135 billion in 1980, a 7,000% increase.

Although 0.99 percentage points sounds small, expenses can have a big impact on your earnings. Consider two funds that earn 8% a year on their investments. Fund A charges 0.50 percentage points. Fund B charges 1.5 percentage points. A $10,000 investment in Fund A would grow to $87,500 in 30 years, vs. $66,000 for Fund B.

Morningstar's Kinnel says that some fund companies, such as Schwab and Janus, have been cutting fees lately, even though assets have fallen dramatically. Some other fund companies have been slashing corporate expenses and payroll to avoid having to raise fees.

But other fund industry moves are harder to defend:

•Fund implosions. Most people expect to lose money in a stock fund during a bear market. But a few bond funds melted down last year, producing losses that would be horrific for anyone. Oppenheimer Champion Income, a high-yield bond fund, plunged 79% last year. Schwab YieldPlus, a short-term bond fund, fell 35%.

•New funds. The fund industry often rolls out new funds to take advantage of short-term market trends. By the time the fund gets approval from the Securities and Exchange Commission to sell shares to the public, the trend is ready to reverse direction and roll over. Direxion Financial Bear 3x Shares, for example, promises to rise three times as much a day as financial-services stocks fall. The fund, which launched in November, plunged 77% in the second quarter, and has fallen 87% this year.

•New share classes. Most people buy mutual funds through a third party — a 401(k) plan or a broker, for example. To increase sales and mask the costs of paying the third party, funds have rolled out a bewildering array of share classes. Class A shares, for example, charge an upfront commission, or load. Class C shares have no upfront load, but higher ongoing expenses.

Choosing among multiple share classes can be confusing, to say the least. Putnam, for example, has seven share classes for each fund. The American Funds can offer as many as 15, some for targeted distribution channels, such as 529 college savings plans or retirement plans, others for different individual investors. Even though the number of mutual funds was barely changed from 2007 through 2008, the number of share classes jumped to 22,239 from 21,618 last year, according to the ICI.

•Scandals. Although nothing compares with the 2004 market-timing scandal, some fund companies are still running afoul of the SEC. Federal regulators charged the Evergreen funds last month with overvaluing one of its mortgage-backed securities funds. Evergreen paid $40 million to settle, without admitting or denying the findings. Also, last week, the SEC sent a warning to State Street Global Advisors that the company could face charges on losses in some of its bond funds stemming from subprime securities.

Despite the fund industry's problems, Dan Wiener of The Independent Adviser gives it a B for its efforts during the worst bear market since the Great Depression. Low-cost exchange-traded funds, for example, give investors a way to invest cheaply and efficiently.

"It has done a terrific job building the ETF side of the business, and a poor job educating investors about those products," he says.

And, says Michael Lipper, the average fund shareholder's experience the past decade depends upon how much guidance his broker or financial planner has provided.

"Some have done a very good job of calming people, and kept their account holders knowledgeable," he says. "But the do-it-yourself investor, I think, has been hurt."