Sunday, March 1, 2009

Who Pays Analysts? All of Us!

Once in a while somebody is publishing article, criticizing analysts forecasts and wondering why are they still being paid huge money. Let me clear the picture a little bit.

Everybody who has any investments with mutual funds pays analysts for their subpar performance. And also fund managers for their even less stellar performance. It's well known that 80% of funds underperform the market. And still there are millions of accounts with many hundred billions of dollars invested in mutual funds. Significant part of this money is invested by morons, oh, sorry, by people who are way too lazy to think. They just go with the flow, invest in what they saw in advertisements, or on advice of relatives and friends. Honestly, I don't feel too bad for these people and if they want to pay for analysts' Ferraris and boats, great.

Unfortunately, there is another source of income for these guys. It's everybody who has a 401k or 403b or any other plan which has a limited number of options. Let's say you work for company which provides 401k plan. And company matches, for example, first 5% of your income you put into the plan. It's just great, you get immediate 100% on your investment! But the problem is that most 401k plans have an agreement with some investment company which has a limited (about 15) number of investment choices. Usually they are mutual funds. And usually there are no index based funds among them. So the picture is simple: we invest in 401k because it's incredibly good investment for us, mutual funds get their money and pay analysts a good chunk of the management fee goes to analysts. Funds get fees as a percentage of managed money, so they don't care about performance. They pay analysts from that percentage, so they don't care about analysts' performance either.

One obvious problem here is that mutual funds aren't allowed to charge performance based fees. But another, bigger problem is that financial companies managing 401k and other plans usually do not provide an index fund option.

I don't know if there is a good solution for this. Disconnect happens first on the company level. Company provides you and me with 401k plan option, but it doesn't care about plan performance. We, 401k investors, are happy with instant 100% return, so we take 401k plan with subpar performance anyway. More regulation probably won't help either.

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