About The Elimination of Mutual Fund Deficiencies
Within Variable Annuities To Benefit All Investors

By Bob Kneisley, CEO, Indicator Advisory Corporation, Money Management Services

Mutual Fund Deficiencies – A Long List

Mutual funds have been around for a very long time. The first such fund was introduced on March 21, 1924. The fund offered an open-end capitalization, allowing for the continuous issue and redemption of shares in the Massachusetts Investors Trust. In the very first year, the fund grew from $50,000 to $392,000.

The Variable Annuity was introduced i

n the 1950’s. The list below provides a few reasons why the application of mutual funds within variable annuities is a concept that should be retired in favor of the increased flexibility of the “Separately Managed Account”, (SMA), reality. We hope that all state Insurance Oversight Divisions will agree so that investment consumers can benefit from the savings and increased customization for all annuity investors.

The Glaring Problems With Mutual Funds In Variable Annuities

1. “Window Dressing”
   Northwestern University describes the term as funds acquiring leading stocks just before their required semi-annual reporting deadline.
2. Misleading Mutual Fund Names
   Some funds stray from their described goals by investing in unrelated stock categories; (example: an “Income” fund invested for growth.)
3. Mutual Funds Altering Fund Names
   Marketwatch has reported that funds sometimes revise their names to whatever term might be in vogue.
4. Closet Indexing
   Fund managers simply match existing index fund holdings.
5. Frequent fund closing and re-opening
   This activity brings in more new money.
6. Fund Obesity
   The premier fund rating firm; Morningstar, claims that some funds grow so large that they mirror the S&P 500.
7. Cloning
   Simply amounts to applying another fund name while cloning an existing mutual fund.
8. Survivorship Bias
   Fund companies can report overall “Family Fund” performance which can hide poor fund performers.
9. Creation Bias
   Fund issuers can create many funds and wait three years, then send their best-performing fund to the Morningstar rating firm, which then awards a five-star rating.
10. Hidden fees
    Fund issuers don’t always report management fees, clearing costs, turnover costs and the impact of capital gains taxes when other shareholders sell. Even the Statement of Additional Information can omit fees.
11. The IPO “Shell Game”
    This occurs when the fund buys an Initial Public Offering stock and holds it until it appreciates before placing it within one of their smaller funds. Doing so bloats the fund’s performance for the rating firms.
12. Too Many Share “Classes”
    Investors face a bewildering number of share classes which adds confusion.
13. Lack of “Quantity Discounts”
    Large investors do not receive a discount based upon the obvious fund savings with large investment amounts.
14. Rising Costs
    Harvard studies have revealed “sale pricing” of fund shares due to late daily reporting.
15. Market Timing
    This practice shifts money in and out of funds increasing taxation for fund holders.
16. Late Trading
    Research has determined that illegal trading exists after market hours.
17. Personal Trading by fund Managers
    This practice finds managers selling their personal holding while buying the same security for their fund.
18. Steering
    Fund issuers can steer profitable “trade clearing” business to “preferred vendors”
19. “Approved” Funds Status
    This is stock brokerage lingo for mutual fund issuers that pay for “shelf space” at brokerage firms so that their salespeople can market the funds to the public. We doubt that any actual research is involved.
20. Excessive Cash and Borrowing
    Some issuers carry heavy cash positions and borrow against fund assets.
21. Style Drift
    This occurs when the fund objective is overlooked and assets drift into a different investment style; an “Income” objective drifts to a “growth” fund objective.
22. Excessive Internal Fund “Turnover”
    Some growth funds turn their inventory over 100% yearly.
23. Fund Manager “moonlighting”
    Research has determined that some fund managers also manage “hedge funds” on the side.
24. Frequent Manager changes
    The fund prospectus is required to be updated only once per year. An investor’s favorite manager may not be active anymore.

Here are some additional points outlined in Dr. Kenneth A. Kim’s book entitled: “Mutual Funds EXPOSED”.

• According to Morningstar, “The average cost of mutual funds’ tax inefficiency is between 1% and 1.2% per year.”
• Hidden costs
  Bid-Ask Spreads=0.23% yearly cost
  Trading Commissions=.25% yearly cost
  Price Impact=.94% yearly
  Additional costs associated with the need to employ an Administrator, accountants, an auditor and a Board of Directors.
• “On average, active funds underperformed the market by around 1.6% points per year.”
• “Incubation” of funds misleads the investing public as does “Leaning for the Tape”, “Window Dressing”, “Institutional Favoritism”…and other “sneaky” activities.

We submit that the above partial list of mutual fund deficiencies suggests that our Direct Management Strategy® would substantially improve variable annuity performance to the benefit of all investors. Our Direct Management Strategy® enhances the SMA concept by omitting the high cost of mutual funds, garnering tax efficiency, fee transparency, increased tax efficiency and investor customization opportunities coupled with high technology Turnkey Asset Management Programs, (TAMPS).