Why Wall Street Lost Badly Last Year

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With most things, you get what you pay for. But when it comes to actively managed mutual funds, paying up for Wall Street's finest gave you terrible results in 2011 -- and there's a very simple reason why.

Understanding the trends
Fund-analysis company Morningstar routinely compares the performance records of actively managed mutual funds to stock market benchmarks. By looking at how mutual fund managers perform compared to broad market measures like the S&P 500, you can get a read on whether the Wall Street pros you pay in the hopes of obtaining market-beating performance actually deliver the goods.

In 2011, the answer for most pros was an emphatic "no." According to Morningstar, nearly four out of five large-cap fund managers did worse than the S&P 500 -- and that's despite the fact that the benchmark index itself did pretty poorly, with the index finishing flat on the year and posting a total return after dividends of about 2%.

The fact that pros underperformed what you could have gotten from a simple S&P 500 index fund isn't all that new. But the sheer magnitude of the underperformance was unusual, as you have to go all the way back to 1997 to find a time when more managers fell short.

What happened?
So how did fund managers do so badly last year? The answer lies in the need for mutual funds to distinguish themselves from the crowd in order to be successful.

Active fund managers are under constant pressure to produce strong results. In comparison to the simplicity, ease of use, and cost-efficiency of index funds, active fund managers face the challenge of overcoming higher operating costs to produce superior returns.

Typically, one way that fund managers can distance themselves from the market is by choosing stocks that don't make up a large portion of the index and using those stocks as their benchmark. For large-cap mutual funds, buying the largest stocks in the S&P 500 opens a fund manager up to criticism as a so-called "closet indexer" and raises questions as to why an investor should pay the higher fees of active management over cheaper index funds.

Think big
Unfortunately, the largest stocks in the S&P 500 actually did quite well last year. The biggest component, Apple (Nasdaq: AAPL  ) , rose more than 25% on the unparalleled success of its iPad and iPhone offerings. Moreover, those gains have continued so far in 2012, which could again put pressure on mutual fund managers to put more money into the iDevice giant.

Elsewhere in technology, IBM (NYSE: IBM  ) also posted a big gain. The company continued to execute on its five-year plan to double profits by 2015, and its success has motivated competitors to make similar moves away from hardware and toward higher-margin services. IBM even attracted a big investment from Warren Buffett.

Similarly, energy stocks ExxonMobil (NYSE: XOM  ) and Chevron (NYSE: CVX  ) performed quite well, each rising around 20%. High oil prices made up for weak natural gas prices at those Big Oil giants, while many of the smaller stocks in the energy industry have greater exposure to natural-gas plays like shale gas. Those plays could prove extremely lucrative in the long run, but they held back a number of small companies during 2011.

Even among underperformers, most of the damage wasn't severe. Microsoft (Nasdaq: MSFT  ) posted a small loss of 4% after dividends, and so far in 2012, the company has rebounded sharply as prospects for its Windows 8 operating system look increasingly favorable.

Back and forth
Of course, megacap giants don't always outperform their smaller counterparts, and that's why mutual fund managers sometimes beat the indexes they track. Yet with their cost disadvantages, it's always an uphill climb -- and all too often, the challenge ends up defeating active fund managers and costing their investors.

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Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter here.

Fool contributor Dan Caplinger hopes to visit the New York Stock Exchange someday. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Apple, Microsoft, and IBM. Motley Fool newsletter services have recommended buying shares of Apple, Microsoft, Chevron, and ExxonMobil, as well as creating bull call spread positions on Apple and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never leaves you a loser.

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