Why Your Mutual Fund Is a Dog
It’s a well-known fact that three-quarters of equity mutual fund managers fail to outperform their benchmark each year.
Large cap fund managers generally don’t beat the S&P 500. Small cap managers don’t beat the Russell 2000. International managers don’t beat the Morgan Stanley Index of Europe, Australia and the Far East (EAFE).
But that’s not the worst part. Over periods of 10 years or more, 95% of them fail to beat their benchmark.
And this 95% number actually overstates the performance of active fund managers. How? Because many new funds don’t make it a full decade before getting closed down.
Here’s an example... Let’s say Merrill Lynch brings out its new Super Duper Small Cap Growth Fund and - right out of the gate - it hits the skids.
Merrill Lynch realizes that its army of salesmen - excuse me... account representatives - can’t sell a fund with a losing track record. Nor do they want this doggie fund besmirching their good name.
So what do they do? They quietly fold the funds’ assets into another better-performing Merrill Lynch small cap fund. The shareholders don’t object since the fund is a loser anyway and the whole mess quietly disappears.
That’s one less fund that underperforms the benchmark for five years... but only because it didn’t make it nearly that long. (And a few months later, Merrill will bring out another small cap growth fund and try again.)
Why do fund managers - who are generally smart folks with plenty of research and a strong desire to pick winning stocks - perform so miserably?
There are a number of reasons. One is that the market is more efficient than most investors realize. Virtually all public information - both positive and negative - is immediately priced into stocks. You have to have a battle-tested proprietary system or know something really special - something most other market participants truly don’t know - to have an edge.
Another reason is overdiversification.
The prospectus of most funds requires them to own lots of stocks, often hundreds. This protects against one or two stocks ruining the fund’s record but it also prevents one or two big winners from having much of an impact.
Part of the reason Warren Buffett has done so well over the past five decades is that he takes concentrated positions. He invests more money in fewer names. If you’re a good stock picker, that’s a big advantage.
Active fund managers also underperform because they don't follow a disciplined sell strategy. You’d be shocked how many professional investors fall prey to the same mental mistakes amateurs make.
For instance, they are likely to consider a sell-off in one of their favorite names a short-term aberration or blame it on market conditions. Sometimes they even average-down on their losers. (When a stock hits zero, it’s not a good feeling to know you doubled and tripled down along the way.)
They also underperform their benchmark because - unlike ETFs - they must maintain a cash balance to meet redemption demands from shareholders. No manager wants to sell his favorite stocks in order to raise cash, but that sometimes happens too, especially in down markets.
To outperform the market, a fund manager has to cover the management fees and other costs that aren’t associated with the index he or she is trying to beat.
Moreover, the law requires funds to distribute realized capital gains to shareholders each year, hitting you with a big, fat tax bill, even if the fund is down for the year. (Talk about salt in the wound.)
Once you truly understand what a loser’s game this is, you simply won’t invest in actively managed funds any more. (For a more complete discussion of this important issue, feel free to read my first book, The Gone Fishin’ Portfolio.)
As the economist Paul Samuelson once said, “There is only one place to make money in the mutual-fund business - as there is only one place for a temperate man in a saloon - behind the bar and not in front of it.”
But are you ready for the really scary part? As Oxford Club Editorial Director Andrew Snyder pointed out in a recent column, the vast majority of investors actually earn vastly lower returns than their mediocre money managers.
According to recent research by Richard Bernstein Advisors, the typical investor has earned less than 3.5% a year over the last two decades.
How they managed to fumble the ball so badly is a teachable moment. I’ll explain what they did wrong - and how you can avoid their missteps and meet your most important long-term financial goals - in my next column.