After opening with a discussion that shows that neither Alison Southwick nor her broadcast partner Robert Brokamp understand how good cop/bad cop works, the pair welcome a special guest into the studio.

That's just the beginning of this episode of Motley Fool Answers, the show that challenges the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves. The pair also tackles how an individual investor should pick a benchmark to judge success against and they learn a little bit about mutual funds from Motley Fool's own Bill Mann.

Mann shares the differences in how a mutual fund works for a fund manager versus how it works for investors. He also share a major confession from the industry which he works in, and a little bit about how to handle related taxes.

A transcript follows this video

This podcast was recorded on October 11, 2016.

Alison Southwick: This is Motley Fool Answers. I'm Alison Southwick and I'm joined by my good cop partner, Robert Brokamp. He's personal finance expert here at The Motley Fool, and advisor for Motley Fool's Rule Your Retirement newsletter.

Robert Brokamp: Behave, everyone out there. I don't know. Is that what good cops say? Or is that Santa Claus?

Southwick: No, a good cop would be like, "I'm on your side. I think you're doing great."

Brokamp: That's right.

Bill Mann: You complete me.

Southwick: Well, I don't know that a cop would say that, but maybe you better be the bad cop. Don't you want to be the bad cop?

Brokamp: I should just sit and be a cop.

Mann: That would be a super-great cop.

Southwick: The other voice you heard was everyone's favorite mutual fund manager. It's Bill Mann, chief investment officer for Fool Funds and Fool Wealth. He's back, but not of his own accord. Cue the Law & Order "dong dong." Bro and I brought him in. We cuffed him to this desk and we told him it was time to confess. And confess he will, with three secrets of the mutual fund industry. All that and more on this week's episode of Motley Fool Answers.

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Southwick: Our question today comes from Oswaldo, and Oz writes: "I just finished listening to your interview with Morgan Housel, and in one of the biases, he mentions that you should be comparing your returns against the S&P 500 as a suggested benchmark. I hear this very often from other money people, and I often wonder the following: How do you define the right benchmark? Or more importantly, shouldn't your benchmark be what you need to achieve your goals?"

And then he talks a little bit about how he's created his own benchmark. He wants to know: "Am I doing something wrong by disregarding the S&P 500 or other benchmarks and simply creating my own benchmark based on what I can actually control, which is how much I put aside?"

So yeah, benchmarks. A little more controversial than I thought. Sort of a hot topic issue, huh?

Mann: There may be a fight.

Brokamp: There may be a fight. First of all, I would say you should most certainly not be comparing everything you do in terms of investing with the S&P 500. The S&P 500 is large-cap U.S. stocks. So if you're going to invest internationally, or if you're going to invest in smaller companies, or if you're going to focus on a sector like real estate or technology, you have to find a different benchmark, I would say.

Mann: I think it's actually OK with your equities to track against the S&P 500 for the very reason that it is so easy to buy an S&P vehicle. An S&P-driven ETF. An index fund. And because it's so easy, I think that it's really OK to say, "I could do that and not have to think about it anymore, but I do want to know what the value of my thinking about it is."

Now, I think the thing that people do wrong is they say, "OK, I'm going to take everything in my portfolio, or all of my investments, and I'm going to compare those to the S&P 500." That would include real estate. That would include precious metals. That's a little bit crazy, because those play a different purpose. There is almost no financial advisor who would say you should have 100% of your money in equities, And so, therefore, you shouldn't have 100% of your money, or your assets, tracked against an equity-driven index.

Southwick: So a reporter did his research and found out that had Trump just invested his money in the stock market, he would be doing so much better in how he brags about all of his wealth, but really he hasn't done that well. But then some other people chimed in and said that's unfair to compare his wealth to the S&P, so stop picking on him.

Mann: Yes. Almost none of that money, as far as I know, was in stocks. I mean, he is a real estate developer. He could have lived a life of luxury, apparently, and done better by putting it all in the market, but who would have recommended what he did to start with. I mean, it's funny...

Southwick: It's entertaining is a good reason.

Mann: That is a great ad hominem article, right there, but I don't think that that is particularly fair.

Brokamp: There is a question of why even bother with a benchmark. One would be along the lines of what Bill was saying. You could just invest in the S&P 500 very easily and in a very low-cost way, so you might want to use that benchmark just as "I'm going to do something a little different and just pay attention." Then say, "Was that the right thing to do, or should I just give it up and stick with the S&P 500?"

The other reason to have a benchmark is to compare similar strategies like similar mutual funds. Like, "I want a small-cap value mutual fund." Well, I've got to look at them and say, "All right, this one is beating the benchmark or it's not." You have to evaluate and make an apples-to-apples comparison.

Mann: Yes.

Brokamp: So it really depends on why you're looking at the benchmark.

Mann: I think it's much more important when you're talking about funds -- you're talking about any type of an investment vehicle -- that you have an appropriate benchmark. And again, going back on what I said before that the S&P is actually OK, you do have to make sure that you've got the right time frames. Like if you buy a bunch of Chinese companies and it trails against the S&P for a quarter, that's not relevant. You're talking about over a period of time that needs to be long enough.

For example, emerging-market stocks have underperformed, fairly dramatically, really over the last three years. If you were investing in emerging markets, would you say, "Well, I have been terrible at it because I trailed the S&P 500." It doesn't make any sense. So with a long enough time horizon, the S&P is fine for everything. With shorter time horizons, I would pick something that is much more relevant.

Southwick: So is it OK that Oz made his own personal benchmark?

Mann: Yeah. Fund companies do that.

Southwick: Are you giving him permission?

Mann: Yes, sure. Just don't change. Just don't say, "Well, I was bad at that, so why don't I just change my benchmark."

Brokamp: I need a better benchmark that makes me look smart.

Mann: Yeah, that's literally it. If it's accurate, and it measures in a long-enough period of time, and it's not changed, it's good.

Southwick: All right, make your own benchmark.

Brokamp: Go right ahead.

Mann: Mine is seven.

Southwick: And are you crushing it?

Mann: Crushing it.

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Southwick: Dong dong. Bill Mann, you have been a mutual fund manager for how long, now?

Mann: Six years.

Southwick: Six years. And before that you had a 16-year career...

Mann: That's bad math.

Southwick: A 10-year career.

Mann: Yeah.

Southwick: That is bad math. See, this is why you're the mutual fund manager and not me.

Mann: Bill Mann, you're 77 years old...

Southwick: So 10 years at The Motley Fool investing. Advising people for a few of our newsletter services and then you made the jump over to our mutual funds.

Mann: Yes, I jumped in and started managing money for real.

Southwick: And we have three mutual funds. I can't really talk a lot about them...

Mann: Yeah...

Southwick: Because it's a subsidiary company.

Mann: They exist.

Southwick: They exist.

Mann: There's a website.

Southwick: You can learn more at FoolFunds.com. One thing that we talk about, when we talk about our mutual funds, is that we created them to be somewhat different...

Mann: Yeah...

Southwick: ...and different from the industry. Different in fees and different in other things. So I don't want to make it sound like you're handcuffed to this desk because you've done something wrong, but you are here to confess about some of the things that maybe people aren't aware of in the mutual fund industry.

Mann: It is very funny, because we will go to conferences and people will say, "Oh, we didn't know you had funds. I thought you hated funds!" And we'd say, "Yeah, maybe we kind of still do."

Brokamp: Except their own!

Southwick: But you say most of them.

Mann: But look here! Well, I think that's true of a lot of things. It is very easy to generalize, and I think it is very easy to say that a lot of mutual funds have not been great vehicles for doing what they're supposed to do, which you would think is enriching the shareholders.

Southwick: Make me money!

Mann: Make me money. I mean, you money. I mean, fund managers, as a group, tend to do OK, because there's fixed, but, you know...

Brokamp: Right. And as a group, the investors in the funds don't get as much as they hope to get, so I think it makes sense.

Mann: Yeah, and there's a lot of structural reasons that that's so, and there's some things that you can really blame the system on. I mean, there are some reasons why [it's hard to make a buck with] mutual funds.

Brokamp: Yup.

Southwick: Well, let's get to your first confession. Bill Mann! What is your first confession for the mutual fund industry?

Mann: So my first confession follows right upon what I was just saying, is that mutual funds are very heavily dependent on what's called non-fixed capital, which is kind of a brutal podcast word. It basically means that every day, people can put money in or they can take money out. And basically what that means is when people put money into your funds, effectively you're selling a little, teeny bit of everything that's in the fund because you're diluting it.

For example, let's say a mutual fund company makes a brilliant investing decision on day one with $1 million, but then five years later, the fund has $5 billion in it. And if they haven't put any more money into that investment idea, it's worthless to them, even if it's gone up 20-100x in value. So you're very much dependent on people putting money in and taking money out. And really, I think one of the core jobs of a mutual fund manager who believes in doing well for his clients is making sure that they are aligned before they come in.

Southwick: And how do you mean aligned?

Mann: Meaning if I say that I'm going to be able to track the market — and every time the market goes up I'm going to do something and every time the market goes down I'm going to do something — the type of investor who's looking for that sort of thing is great.

But if I say, "Look, my job is to go out and find really great companies and 10 years from now I believe they will be higher," then those ups and downs are things that I'm not really trying to account for. I'm just trying to find great things. So someone who panics when the market drops 15% is probably not well aligned with a fund manager who invests like that.

Brokamp: But then you and the other shareholders — you as the manager — have to pay for that, because if the market's going down, you'd love to be buying more. But if a bunch of shareholders are saying, "No, I want my money back," you're forced to sell at a time when you would prefer to be buying.

Mann: Yes, that's exactly right. And you hear investment managers say this a lot, and this is actually a very admirable thing for them to say, is that one of the greatest gifts they can have is well-aligned investors. Because it's right. If you have well-aligned investors, they're much more likely to be sending you money at the time when you want it, and they're much more likely to be taking money away when you aren't finding too many great ideas.

Brokamp: Right, and all that selling and buying can be an extra cost to the shareholders...

Mann: Yeah...

Brokamp: There can be extra tax consequences, so it helps the shareholders to have other shareholders that are similarly minded.

Mann: Yeah, that's exactly right.

Southwick: Let's move on to your next confession.

Mann: Was I good at confessing? Was that OK? Did I confess? I feel like I've gotten something off my chest.

Southwick: You've got two more confessions to go.

Brokamp: Wait until you hear the penance, though.

Mann: That's right. It feels more like a confessional...

Brokamp: Says the guy who was studying to be a priest at one point in his life.

Southwick: Yeah, you're going to have to take on that one. I can't help you there.

Mann: So my next confession is that there are lots of hidden costs in mutual funds that you have to pay attention to. The biggest one we just mentioned a second ago, which is taxes. [Let's say] you buy a mutual fund and you do nothing over a 10-year period. With a stock, that means you don't have any taxes to pay. But with funds, the shareholder gets a tax bill every year based on the activity of the fund. So even if you do nothing, if I do lots of things and I'm not tax-efficient about it, you get capital gains and you pay taxes on those capital gains. And it's not tracked, and unfortunately a lot of fund managers, therefore, don't spend much time thinking about it. I happen to take taxes very seriously, and I happen to take those costs very seriously, but it's very much of a hidden cost.

Another cost is the spreads, which is if you want to buy a stock right now, it's got a bid and an ask. That means that you can buy the bid and sell the ask... I'm dyslexic. Is that right?

Brokamp: I don't know. I never pay attention to this.

Mann: I'm seriously dyslexic...

Southwick: Oh, that's OK.

Brokamp: It's so funny, because you and I are in the same thing. Every time I talk about the bid-ask, I have to think about...

Mann: You have to think about it.

Brokamp: ...which one is...

Mann: Exactly.

Brokamp: It's the difference between the price you would sell it at and the price you would buy it at.

Mann: Exactly. And there's a spread between the two. And if you are buying, you're buying at the higher price, and if you're selling, you're selling at the lower price. There's a gap, and it's tiny, but the more times you transact, the more times you, the shareholder, are paying.

Southwick: I don't think I understand this. So if I imagine the stock market, and there's this one person who is like, "I would like to sell a share of Apple." And I'm like, "Oh, I would like to buy a share of Apple." And they're like, "We're going to sell it to you for $5." And I'm like...

Mann: Awesome, I'll take all of it.

Southwick: Obviously Apple's going to be worth more than that. But they're like, "I'm going to sell it for $5." And I'm like, "Well, I'm going to buy it at $4.99."

Mann: Something like that.

Brokamp: Because there's someone in the middle of that transaction — the market maker or the market — and that's essentially their profit. If you think of stock as an inventory, I'm going to buy it (the market maker) at the lower price and then sell it at a higher price.

Southwick: That's because there's a middleman. The middleman gets a cut.

Mann: Yes. There's nothing nefarious about this. The middleman is providing a service, so it's fine for them to get a cut, and the more liquid the stocks are, the narrower that spread is. But there's still a spread, and every time you transact, you're paying it.

Brokamp: Right.

Mann: You don't write a check. It doesn't come out of your pocket or even the change in your couch, but you pay it.

Brokamp: Right. And related to that, most people look at the expense ratio of a mutual fund to get an idea of the cost. But the commissions that funds pay to make these trades are not captured in that expense ratio.

Mann: That's right.

Brokamp: The expense ratio doesn't capture all the ways you're paying money.

Southwick: So how do you find out all the ways you're paying money? Also, we should mention 12b-1 fees...

Mann: Yeah...

Southwick: ...which are awful. But how do we find out about all the other ones?

Mann: The best way for that one is to pay attention to the turnover of the fund, which is the percent of the fund, each year (or in the past year, I should say) that has been transacted.

Brokamp: So if you have a turnover ratio of 50%, theoretically that means half of what you have in your portfolio wasn't there a year ago. You've switched out half of your portfolio. So a lower turnover, like 10-20%, is really low. It means you're still holding 80% of what you had a year ago. Higher than that means the fund manager is doing a lot of buying and selling, paying a lot of commissions, and generating a lot of tax consequences.

Mann: And the awesome thing — this is really great. Sometimes you see a fund that has a turnover ratio of like 160% (which is not uncommon). We've seen it — 160%. That means that the average holding, roughly, is eight months old. But you go and you read their prospectus, and they'll say things like, "We're in it for the long term." There's no such thing. It does not match, and that's actually a really interesting, key thing to look at. Does that match what they say?

Southwick: What's your turnover rate, Bill?

Mann: About 26%. It's actually a little higher than it should be just because every year we do try to make sure that we are tax-efficient. So sometimes we will move things to do some tax-loss harvesting, we call it. Things that we'll buy back, because it's really our goal, each year, to provide a zero tax bill. I'm not saying we do it or will do it, but we definitely try to.

Brokamp: A final point on that. There was a study published in the Financial Analysts Journal in 2013 that looked at hidden costs. There certainly is a relationship between funds that have high costs — they subsequently have lower performance — than the funds that have low costs. So it really does matter.

Mann: It really does.

Southwick: All right, Bill. What is your final confession?

Mann: I'm going to confess on behalf of my industry. This is a global confession. A lot of people who believe that they're getting actively managed portfolios in mutual funds are getting something that is much more like an index fund than they might think.

Southwick: They're paying way more money for it than an index fund.

Mann: Of course. That's how it works. So if you think about risks, your risk as someone who invests in a mutual fund is way different from the mutual fund manager's risk. The mutual fund manager basically doesn't want to get fired.

Now how do you not get fired? Well, you don't get fired, first and foremost, by not really trailing the benchmark. The easiest way to do that is to have your portfolio look as much like your benchmark as possible. Probably for years that was a great idea. Now with the advent of index funds and exchange-traded funds that match things, it basically means you're paying a lot more for the same exact knowledge.

And it's not even knowledge. I mean, if you are a "closet indexer," and that's the not-so-nice term for people who do this, and you are tracking the S&P 500 as your benchmark, you have to own Apple, and you have to own a lot of it. But not only do you have to own Apple, but you don't have to spend a second thinking about it. You don't care whether the Apple Watch is going to be big, or the Apple TV is going to be big. You just know that Apple has to be a fairly large percentage of your portfolio; otherwise you are taking a risk.

So I don't think that this is great. I would hate to be at a fund company where this was something that was widely accepted. There is something out there that's called Active Share, which is a way that you can tell how different a portfolio is from its benchmark. There's academic research out there that shows that the higher a fund's Active Share (not on a one-to-one basis), [the better] they tend to outperform over time. It is a very good sign of a fund manager who is actually doing the work themselves.

Southwick: So if the contents of my mutual fund are surprisingly very similar to the benchmark, then naturally I should probably just be investing in that benchmark.

Mann: It would suggest that their risks are not necessarily aligned with your risks.

Southwick: Worth my money.

Brokamp: Today I just read one of the studies about Active Share, and one of the findings is the funds that have the lowest Active Share underperform, because they are essentially index funds but charging higher fees. You just can't beat an index fund doing that.

Mann: Well, exactly, because you're going to lose by the amount of the fees, so you're almost guaranteed to trail by, say, for example, 0.8% per year. That doesn't sound like a lot — that's 99.2 cents versus a dollar — but if you compound that out, it matters. It really, really does.

Brokamp: To the tune of tens of thousands of dollars it really does matter.

Mann: It really does. So I would not want to be in a shop where closet indexing is a thing.

Southwick: How do I find out what the Active Share is for my mutual fund?

Brokamp: Unfortunately because the research is relatively new, and somewhat controversial (at least there are some people who have some doubts about it), it's not publicly available. I think one thing you can do is when you go to the fund on Morningstar.com and look it up, go to the Portfolio tab. It will say how much that fund deviates from the benchmark by sector, size, valuation. So you can get an idea how different it is that way. Certainly if it is lining up very closely to the benchmark, I'm going to say it's probably not worth it.

Southwick: All right, Bill. I wanted to thank you for being an informant in the mutual fund industry. Revealing some of the crimes and misdemeanors therein. I'm glad to hear that you are innocent of these, I think. I think we can agree that you're free to go.

Brokamp: Yeah, innocent of these things. We'll see about the other things.

Southwick: The other things we've got to talk a little bit more. All right, that's all for this week. I want to thank Bill, again, for joining us. Thanks for making the trek up to the fourth floor, here. If you want to learn more about Bill and Motley Fool Funds, you can head to FoolFunds.com. That's F-O-O-L-F-U-N-D-S dot com.

And if you have any burning questions for us in the meantime, you can go to [email protected]. This show is edited dangerously by Rick Engdahl. For Robert Brokamp, I'm Alison Southwick. Fool on!