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A Motley Fool and His Money Are Soon Parted

Even if you're just starting out as an investor, chances are good that you've heard of the financial site the Motley Fool. The wisdom of the site appears to go along with the right way to invest:

  • "Since most funds' fees leave them underperforming the market indexes, the key is to find a fund that at least matches the market and has minimal fees. There is an easy way to do just that. You need only buy a passively managed fund that tracks the index and charges super-low fees. Enter index funds. On the whole, index funds have lower expenses and are more tax-advantaged because their holdings don't turn over as much."
At first glance, it would appear that the Motley Fool is fighting on the side of angels when it comes to your investments. However, as I point out in my latest book The Quest for Alpha, it isn't enough to just talk about the right way to invest. You must also practice what you preach. And the Motley Fool falls far short in that department.

In June 2009, the company launched its Motley Fool Independence Fund (FOOLX). The fund's objective is to create long-term capital appreciation. That seems like a simple goal, given the site's previous advice to have a passively managed fund with low fees. However, the fund charges a net expense ratio of a whopping 1.38 percent.

In addition, the fund engages in active management, noting that "performing rigorous, fundamental analysis, we dissect each company's strategy, competitive position, operations and performance, and we review all pertinent public documents and official communications about the company." In other words, the company is looking at the same documents as thousands of other analysts, trying to outsmart the collective wisdom of the market.

As if that's not enough, in November 2010, the Fool launched its second assault on investors with the introduction of the Motley Fool Great America Fund (TMFGX) which carries an equally offensive expense ratio of 1.35 percent. Here's what the Fool's Web site has to say about the fund: "Let's face it: With dozens of Wall Street analysts watching their every move, the market is much more efficient at valuing widely held S&P 500 stocks. As a result, when you concentrate on these names, you not only risk missing out on the growth opportunities offered by smaller companies ... You are pitting your wits against the most educated, highest paid analysts in the world -- thousands of them. We believe this explains why years of data compiled by Ibbotson Associates indicates that, as a group, small and mid-cap companies historically out-perform their large-cap peers."

What the Fools fail to point out is that there's no evidence that active management works in any asset class -- the market cap of the companies doesn't make any difference. Why should we think the Fools will succeed when companies with far greater resources like SEI and Russell have failed to outperform in the small-cap arena? And to get the higher expected returns of small-cap and mid-cap companies, all one has to do is invest in index funds in those asset classes. And further, to believe that small and mid-cap companies have outperformed because they're underresearched is nonsensical.

First, there is plenty of research going on. And more importantly, these stocks have outperformed because investors believe they are riskier, and thus price that risk accordingly. In other words, smaller companies have higher costs of capital, and the flip side of a higher cost of capital is a higher expected return to investors.

Perhaps the worst part of this scenario is that the Motley Fool isn't just going against its own advice, but even its own past failures. Tomorrow, we'll look at the last time the site tried to outperform the market.

More on MoneyWatch:
Does SEI Add Value? Does Russell Add Value? Quest for Alpha: What You Need to Consider When Handling Your Own Investments How Serendipity Plays a Role in Returns Why Keeping Your Investments Local Is a Bad Strategy
Three ways I can help you become a wiser investor:

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