FOOL'S SCHOOL DAILY Q&A

Underperforming Index Funds?

Q: I read that in the second quarter of this year, the majority of actively managed mutual funds outperformed the S&P 500 index, and therefore the passive index funds (which track the S&P 500 market index). Should I be looking to invest in mutual funds other than an S&P 500 index fund? -- S.M., via the Internet

A: We've read a couple of those types of articles, and we're pretty amused -- and more than a little bit concerned by what the authors are leaving out of their reports. Let's examine a fairly representative example, from SmartMoney.com:

"After three years of dismal returns, mutual funds are finally on the rebound. In the second quarter, a surprising 65 percent of U.S. stock funds beat the Standard & Poor's 500-stock index, with the average fund returning 10.2 percent -- three points above the market. That's a serious improvement over last year, when only 19 percent of actively managed funds squeaked by the S&P and 310 funds ended the year in the red. ... What's behind the sudden turnaround? It certainly isn't massive reform within the fund industry itself. ... The simple truth? For the first time in years, the current market is favorable to funds."

Hogwash.

What the article failed to mention is how selectively chosen the time frame was to show a period in which managed mutual funds were beating the market. Why draw any conclusions from what happened between April 1, 1999, and June 30, 1999? After all, if you include the first half of the year, from January through June, it was still the case that the majority of mutual funds were underperforming the market's returns. More telling, if you look over the last three, five or 10 years, more than 80 percent of actively managed mutual funds have underperformed index funds.

The selective use of data over a three-month time period cannot possibly be used to show that all of a sudden "the market is more favorable to funds." Put another way, if there has been no reform in the mutual fund industry -- as the SmartMoney.com article concedes -- then the conditions that created the poor performance for mutual funds are still in place, and there can be no change in an investor's expectations for how actively managed mutual funds will perform over a longer time period. Simply put, good luck explains the second-quarter results -- and good luck really doesn't hold up for very long.

Of course, magazines that derive a significant amount of their revenue from mutual fund advertisements aren't likely to publish any issues stating that index funds are still the only mutual funds that an investor should look at. They are much more likely to run covers with screaming headlines like "Ten Hot New Funds to Buy Today!" Ignore any magazines with covers like that, and stick to index funds as the best choice for your long-term savings.

WHAT NOW? Overwhelmed by the number of mutual fund choices in your 401(k)? Check out www.fool.com/money/401k for guidance, hand-holding, and some lighthearted fun at the expense of the Wise men of Wall Street. And for more on the wonderful world of mutual funds, head to our School area.

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