I’m talking about a little chart that appeared in this week’s Economist magazine. It showed the top-10 best-performing funds from 1996 to 1999, and their subsequent performance over the following three-year period. Reflecting the performance of the 851 largest funds, the chart’s revelations were shocking. The bottom-line conclusion to be drawn from this chart: Mutual funds are anything but the super-safe and stable instruments their advocates claim them to be.

For example, the top-performing mutual fund from 1996 to 1999 came in 841st over the subsequent three-year period. And the #2 fund from 1996 to 1999 came in 832nd over the subsequent three-year period. In fact, there appears to be little if any correlation between past and future performance with a lot of these funds. What in one case was a winner during the first three-year period lost an average of 30% per year during the second three-year period! (You can see this chart at http://www.economist.com/images/20030705/CSU152.gif.)

From looking at this simple chart, it is clear that steering away from mutual funds altogether can be a good method for keeping your investment dollars from stagnating - or, worse, disappearing in a fund whose performance is no more predictable than an individual stock’s.

The Comedy Of It All

The real comedy here (if you can even laugh about these things) is that mutual funds are generally sold to the public based on their recent performance. In essence, mutual fund companies are knowingly selling the funds that have done well recently funds that they know are probably past their prime and due for a period of severe underperformance.

Understanding this, it’s no surprise that the average individual investor in mutual funds was only slightly profitable over the great bull market The average mutual fund investor turned $10,000 into only $16,200 over the 18-year period ended 2002 - during the greatest bull market in history. This figure comes from John Bogle, who founded Vanguard Funds back in 1974. Bogle says the performance of individual investors was so poor because they switched in and out of hot funds chasing past performance - exactly what the fund companies were pitching. For comparison, $10,000 invested in the S&P 500 stock index over the same period (the 18 years ended 2002) would have turned into $89,000.

In return for the “promise” to outperform the overall market, mutual fund companies earn handsome fees. Are the fees worth it? According to Bogle, not at all $10,000 invested in the average stock mutual fund would have turned into $52,000 over that same period-a horrible underperformance when compared to the $89,000 tally the index turned in.

Said another way, supposedly “professionally managed” investments couldn’t beat the unmanaged index. The logical conclusion is, don’t pay the managers.

Whose Best Interests Are The Funds Looking Out For?

You’d think that things would be getting better as the fund business has grown. And my, has it grown Assets in the fund business increased from $56 billion to $6.4 trillion during the great bull market.

Since many of the expenses are basically fixed (all funds of any size must pay rent, and auditors, and the list goes on), you’d think that with the explosion in assets, the annual expenses per shareholder would have fallen dramatically. Instead, according to John Bogle, the average expense ratio at a fund has risen from 0.91% in 1978 to 1.36% today.

The average mutual fund charges 1.36% a year in fees. The annual average fee at Vanguard, John Bogle’s company, is 0.26% a year. Why are Vanguard’s fees so much cheaper? Many of Vanguard’s funds are “unmanaged” funds they just attempt to mimic the performance of an index no super-expensive superstar fund manager needed. Who needs a “superstar” manager anyway?

“The Law of Averages” was the title of this week’s Economist article. Clearly the top-10 fund managers of 1996 to 1999 - the “superstar” managers-were not so super after all.

What Should An Investor Do?

The answer for you and me as investors probably lies in the world of unmanaged funds - index funds and ETFs. These funds have no “active” investment manager. They simply try to mimic the performance of an index.

Index funds and ETFs (”exchange traded funds” - mutual funds that trade like stocks) exist for every style of investment. Want to stake your claim on South Korean stocks? The cheapest, easiest way is to buy the ETF for Korea. It trades in the U.S. under the symbol EWY. Want exposure to corporate bonds without the fees of a mutual fund or the hassle of buying the fund yourself? Then buy LQD, a corporate-bond ETF. (Or if you want to “short” the corporate-bond market, you could sell LQD short.)

The world of ETFs and index funds is a good one to learn more about. And that is especially true considering the performance of mutual funds over time.

Good Investing,

Steve

Today’s Investment U Cribsheet

• To learn more about ETFs, visit www.ishares.com or www.etfconnect.com. To learn more about Vanguard’s Funds and John Bogle, visit www.vanguard.com.

Related Articles

• Fund Managers: Why do I Listen to Them? Because This Award-winning Study Shows They’re an Excellent Contrary Indicator
• Mutual Fund History: The Terrible Truth
• Socially Responsible Investing: Vice Trumps Virtue On Wall Street
  

Investment U Archives