When hearing the latest news regarding Bernard Madoff, head of the $50 billion dollar ponzi scheme, I couldn't help but ask the questions, was it a ponzi scheme or a pyramid scheme? What is the difference between Mr. Madoff's performance and a mutual fund's performance? Weren't they both managed by an investment professional of some sort? I guess one significant difference is the fact that Mr. Madoff was well respected by Wall street while the average mutual fund manager is not so well known or highly respected. I ask myself these questions despite the belief that I think I already know the answers.
First, it might be helpful to get a better understanding of what the difference is between a Ponzi and a pyramid scheme. A Ponzi scheme is described as, "profits that are promised from a fictitious source and early participants are paid off with the funds of new participants." A pyramid scheme is described as, "a money-making scheme in which people are recruited to make payments to others above them in a hierarchy while expecting to receive payments from people recruited below them." Honestly I can't discern the difference between the two but maybe someone can point out to me the distinction. However, this brings to mind what I have always felt is going on in the mutual fund industry.
It seems to me that mutual funds exist for the sole purpose of having new investors or new money added to their funds. If a mutual fund were to have a large portion of the shareholders sell, say 15-20%, then the fund would be forced to get out of stocks that it holds regardless of the high quality and low price that the stock was initially purchased at. As mutual fund shareholders sell then the others who had no intention of selling become fearful and consider withdrawing their funds. Things have gotten so bad lately that some "hedge" funds have withdrawn shareholders ability to get out when they want to. Why are investors not allowed to get out when they want to? Because if too many people got out at the same time then there wouldn't be enough money to go around. Does this not seem like a scheme of the pyramid or ponzi variety? It is no wonder that the prevailing mantra of the mutual fund industry, and their friends in the various media outlets, is buy and hold for the long term.
During the period of the 1960's there were momentum mutual funds that existed solely for the purpose of buying small illiquid companies so that they could push up the price of the stock and then sell those shares when other momentum funds would follow into those previously unknown companies. The value of the stock had no merit for rising other than the fact that a mutual fund was buying into it due to its lack of liquidity. This, of course, was a story that didn't end very well for the investors but it became quite lucrative for the fund managers.
Likewise, the period after 1929 showed that investment trusts, the mutual fund of that period, were essentially a legal form of a investment pool. Although the pooling of money was supposed to be outlawed, investment trusts ran amok controlling the price of company stock and forcing mergers of unlikely and incompatible companies. Another phenomenon of the late 1920's that we're only now seeing emerge and possibly fade just as quickly is the "fund of funds." This concept, the laziest of the lazy investing models, invests in other investment trusts that invest in stocks. If the era of the stock market wipeout in the 1930's is any indication these funds will be eliminated from the investment lexicon for some time or until the next mania in stock begins again.
At the time, all of these ideas seemed great yet in the end it was abundantly clear that the only reason that something is labeled a mutual fund and another is labeled as a ponzi scheme is the duration at which someone is able to hold onto their investments before getting out. Sometimes there is a gain and sometimes there is a loss. For the time being, many people are willing to accept the fact that their mutual fund is a legitimate operation despite the horrendous amount of their losses this year. But there will come the time when investors realize that, in fact, they have been taken for a ride. After all, the whole reason they invested in mutual funds was because they wanted diversification with the help of a professional money manager so that they would not have big losses. What will be the final trigger? What will make people realize that mutual funds are a financial product and nothing more? If an investment manager could lose 30% of someone else's money and be considered a success in 2008 then what will it take for an average person to become a better than average investor for themselves?
If only the small investor allows for the compounding of knowledge of the basics of investing there would be no need to hand money over to someone else to manage their financial affairs. A great book that outlines the exponential benefits of taking the time to learn about investing is titled,
"Investing, The Last Liberal Art" by Robert G. Hagstrom. I wasn't introduced to this book until long after starting down this path, however I can attest to the virtue and remunerative benefits that have been accrued by doing my own research on the topic of investing.
Sadly, we're not at the stage where the small investor has learned to back away from the green felt parlor table. If history is any indication, we'll have to see even greater losses before the small investor realizes that the benefits of managing their own money far outweighs giving it away to the professionals for a fee. Touc.
Sources:
Hagstrom, Robert G. Investing, The Last Liberal Art. Texere. 2000.
Dreman, David. Contrarian Investment Strategy. Random House. 1979.
American Heritage Dictionary, Fourth Edition. Houghton Mifflin. 2000.
