Mutual funds are the worst possible structure for managing money. They buy too many companies, they have too much money, and the money is always flowing the wrong way; in when stocks are going up and therefore expensive; out when stocks are going down and getting cheaper. The short-term nature of most media attention encourages the movement of money and gives managers an incentive to gamble with their customers' money.

"Style Drift" What happens when mutual fund managers chase performance at the expense of investor suitability rules.

"A Different Drummer" Bogle says that during the greatest bull market in history the average equity fund investor has received just 2.7 percent per year. In other words, after taxes and inflation the average Joe that had his money in mutual funds for the last eighteen years is probably in the hole. This is indeed something to ponder. At first it does not seem possible, but mindless pursuit of performance gets the crowd to always buy last year's winners and we all know how that turns out.

"Which Index Fund" There are hundreds (maybe thousands) of index funds and they are all basically sector funds. Some of these indexes will return something close to the returns of the S&P 500 during the twentieth century. Some will do better, some will do worse, but if you know which is which, you are a lot smarter than I am.

They operate under rules that were written in 1940 and while the rules were well intentioned and effective when written. However, that was sixty years ago and there has not been any meaningful change since. They cause problems in today's market. Regulations written in 1940 encourage over-diversification. These rules have led most large funds to own too many stocks (200 to 300.)

Holding this many stocks makes the investment process very expensive. If you have 300 stocks, you have to have 20 analysts. Analysts have to have assistants. All of these people have to be kept busy to justify big paychecks. That means they have to have lots of computers, travel all over the world, and talk on the phone when they are not flying or using their computers.

If you were going to invent an investment vehicle with a cost structure exactly the opposite of Berkshire Hathaway, this is what you would invent.

The biggest problem is size. Mutual funds have too much money— collectively and in most cases individually.

Since they have very high expenses, they have to be very big if the management company wants to make any money. But the bigger the fund gets, the harder it is to out perform the averages. Peter Lynch quit when the Magellan Fund got to $20 billion. He quit because he knew that he could not continue to perform like he had in the past, and because he discovered in the 1987 crash that the flow of funds at critical points is in the wrong direction.

The bigger the fund, the smaller the universe of stocks that they can invest in. But as the number of choices you have as a manager is going down, the cost of your mistakes is going up.

Funds keep getting bigger so their expense ratio will be lower. But the expense ratio is not the biggest frictional cost. As the amount of money to be invested goes up, the manager has to take a bigger position in each stock in the portfolio. The bigger the position, the more you move a stock up getting in, and the more it goes down when you get out. This is a frictional cost just as real as the expense ratio. Unlike expense ratios, there are no good figures as to how large this cost is. Today's Wall Street Journal says the industry-wide expense ratio for 1999 will be 1.48%. This is what it costs for all the fund managers, their analysts, all the airplane tickets, computers, janitors, rent, and the commissions on the stock they buy and sell. But what did it cost those mangers to get in and out of a position? No one knows. I have never seen what I consider a reliable figure for this expense. I have seen estimates of anywhere to 1% of the position to 7%, but both of these figures came from fund managers so I would guess they are on the low side. If you own a thin stock and your estimate of earnings is a bit high, it might cost you 50% to get out of the position if you wait for the announcement. One assumption does seem clear, the bigger the fund, the higher these transaction expenses.

The irony is that the funds push to keep getting bigger to lower their expense ratio, but as they get bigger their cost of getting in and out of a position is probably going up a lot faster than their expense ratio is coming down. They push to get bigger because they think it will make it easier to out-perform the market. But it just keeps getting harder and harder. The harder it becomes to out-perform, the more irrational the game becomes.

For open-ended mutual funds the flow is in the wrong direction. At the bottom of a bear market, when the best values are available, when the manager can buy good stock at a reasonable price, the money is flowing out like crazy. Customers having watched the account decline in value are usually pulling money out of stock funds at the bottom.

Just as bad, or maybe even worse for investors, is at the top of a speculative bubble (March 2000) money was pouring into speculative stock funds. Managers are afraid of holding cash, because it will penalize their performance. They used this flow to load up on tech stocks that would shortly turn to excrement.