Investments That Don't Stand a Chance

Since 2007, many investors have seen their long-held beliefs about investing shattered. Yet at least one thing remains true: The typical mutual fund managers still can't match their indexes -- even when those indexes' performance isn't exactly stellar.

A recent study from Standard and Poor's confirms that over the five years ending Dec. 31, 2008, a huge majority of active fund managers failed to match the performance of the indexes their funds track. In particular:

• 70% of large-cap domestic stock funds couldn't beat the S&P 500's 19% loss.
• 80% of government or investment-grade bond funds failed to match their respective benchmarks.
• The S&P SmallCap 600 index outperformed more than 85% of all active small-cap funds.
• An index of emerging market stocks beat nearly 90% of emerging-market funds.

These results are nothing new -- historically, over relatively long periods of time, this level of underperformance is fairly typical for active mutual funds. From these results, you can draw two conclusions:

1. It's OK to use index funds.
2. If you decide to swing for the fences, you've got to tilt the odds in your favor.

Indexing is good for everything
For a long time, people have debated whether index funds were appropriate for every market. Apart from partisans who hold positions on both extremes, some middle-ground analysts have sought to find niches in which active management could produce an edge.

For instance, active bond funds, whose returns tend to be fairly low compared to the fees they charge, find it especially hard to make up for their higher fees. In the bond world, it's a lot tougher to recoup a 1% fee disadvantage than it is for a stock fund. And even with large-cap stock funds, the fact that active funds often chase the same stocks as indexes makes it harder for them to outperform.

Yet some believed that other, less-followed sectors, such as small-caps and international stocks, offered a chance for active managers to beat the indexes. This survey proves them wrong as well.

As a result, if you can't find an active fund you like, you should always feel fairly secure investing in an index fund -- regardless of what asset class you're looking for. While you might not get top-notch returns, you should manage to beat the average fund.

Going for the gold

On the other hand, some investors find that settling for average just goes against their grain. While few funds beat the market, some do -- and those winning funds tend to have a combination of these characteristics:

• Lower fees. The lower a fund's expenses, the easier it is for a manager to break even relative to the fund's benchmark.
• Experience. A new manager can't expect to jump in and automatically do well. Those managers with more time under their belts, however, have seen more and know what to do and which mistakes to avoid.
• Good stock-picking. If your manager just picks popular stocks that everyone else follows -- and that make up a large portion of their benchmark -- then they're basically giving up the chance to outperform.

Let's focus on this last point, because it has some surprising ramifications. Consider, for instance, just how many mutual funds own shares of some of the largest companies in the S&P 500:

Source: MFFAIS, Yahoo! Finance. Fund holdings as of Dec. 31, 2008.

Funds that own stocks ranking near the top of the S&P in market-cap weighting may be "closet indexers," making only minimal attempts to outperform the index.

But that's not going to get you strong results. If you want a good shot at doing better than that, you have to find funds that aren't afraid to take chances. They may lose, but at least they stand a chance at outperforming.

An active fund that only seeks to match its benchmark is a waste of your money. If that's all a fund can offer, you're much better off going with the index fund.

More on mutual fund investing:

• The key to finding a great mutual fund.
• Is this the death of equities?
• Or is it the green light for a recovery?