2 Things You Need to Know About Mutual Funds

So you don't have the time or the interest to pick stocks on your own. No problem -- most people don't. And congratulations for being honest with yourself.

You've chosen instead to put your money into mutual funds, letting an experienced money manager do the dirty work for you.

Is that a wise move? Here are two important things to keep in mind.

1. Fees can devastate long-term returns
You've probably heard that most mutual fund managers fail to even match the performance of a benchmark like the S&P 500. If you haven't, here's the deal: According to Standard & Poor's, two-thirds of actively managed stock funds have underperformed the S&P 500 over the last three years. About the same portion have failed over 10-, 15-, and 20-year periods. Out of more than 7,000 mutual funds, eight have bested the S&P 500 every year for the past decade. Seriously. Eight.

That's the single most important statistic you need to know when thinking about mutual funds, since any investor can buy an S&P 500 index fund and mimic the benchmark.

It's also important to know why so many mutual funds fail to beat the index. There are many reasons, to be sure, not least of which is that so many managers just aren't good at what they do.

But fees are one of the biggest reasons the mutual industry fails to perform.

Investment management is a difficult business. If a money manager can finish a career beating the S&P 500 by a percentage point or two per year, they'll have a statue built for them. Think about this: Bill Miller of Legg Mason is almost universally known as one of the greatest mutual fund managers of all time. How did he do? From 1991 through 2011, his Legg Mason Value Trust turned $10,000 into $63,000, according to Morningstar. Investing in the S&P 500 over that period turned $10,000 into $59,000. Annualized, that's 9.1% vs. 8.8% a year, respectively. Almost indistinguishable.

And he's a legend, remember -- a one-in-ten-thousand, literally.

Miller's an incredibly smart guy. He made some bad bets during the last few years, but he's still a great investor. What really crushed his long-term results were management fees. The Value Trust's 1.77% annual fee set a high hurdle to beat every year before the fund even caught up the benchmark.

If you want to see how fast fees take away from long-term returns, check out this Vanguard calculator. Take a mutual fund that matches the performance of the S&P 500 (a top-tier fund these days), but charges a management fee of 1% more than an index fund. With an investment of $10,000, by the end of 25 years the index fund investor will have $13,000 more than the mutual fund investor. That's the kind of thing that should give long-term investors the shivers.

2. You're not off the hook
The allure of mutual funds is that it supposedly lets investors off the hook, giving someone else the responsibility of managing your money.

But that's not the whole story. No matter what fund you invest in, the most important decisions are still made by you.

One study by Dalbar showed that the S&P 500 returned 9.14% a year over a 20-year period ended 2010, but the average investor earned 3.83% a year. Why? Mainly because they bought and sold at the wrong times -- getting into the market just as stocks were expensive, and bailing out just as they got cheap.

It's the same for mutual fund investors. Another study found that mutual fund investors earned an actual annual return of 1.6% below their funds' stated performance from 1991 to 2004 due to buying high and selling low.

Even the best investors in the world get bucked around by the ups and downs of the market. If you fall victim to the emotions of those ups and downs, your investments will do poorly no matter what "legendary" fund manager you put your money with. Buying and selling at the wrong time means it's possible to invest with a talented fund manager who earns great returns and still lose a lot of money. Indeed, that seems to be the norm.

So what do you do now?
There are some very good mutual funds that are worth their fees and worth your money. They exist. There's no reason to detail them here because that isn't the point of this article.

This is the point: For passive investors who don't want to spend time following markets or picking winners, there are better, safer, options that will help you build wealth over time: index funds.

Take an index fund like Vanguard's Total Stock Market (NYSE: VTI  ) ETF and related mutual fund.

The Total Stock Market Index owns a tiny bit of just about everything -- 3,313 companies, to be exact. The fund's distribution is fairly dispersed, but still weighted toward the largest names, with the top five holdings -- ExxonMobil (NYSE: XOM  ) , Apple (Nasdaq: AAPL  ) , IBM (NYSE: IBM  ) , Microsoft (Nasdaq: MSFT  ) , and Chevron -- making up about 10% of the fund. That means it has participated in the tech boom that has lifted Apple and IBM so high -- even if it largely left Microsoft behind -- as well as the big energy rush that has reawakened domestic oil and gas production and helped boost Chevron and Exxon in the process. Yet its goal is not to beat the market; it is to be the market while charging the absolute lowest management fees.

The rationale is simple. The total return earned by equity investors in aggregate in any given year is whatever the market generates, minus management fees and transaction costs. Vanguard founder John Bogle calls this "the relentless rule of humble arithmetic." It goes like this:

  • Over half of all investors must underperform the market average, since fees subtract from the aggregate market return.
  • Thus, you can do a little bit better than the average investor by being the market average and keeping your fees as low as possible.                                                                                                               

Being a hair above average isn't half bad, either. Since 1993, the Total Stock Market Index has produced an average annual return of 7.5% per year.

Of course, investing in index funds can be futile if you fall for the same trap of buying high and selling low described above.

There is, however, an easy fix: dollar-cost averaging, or purchasing an equal dollar amount of stock every month or every quarter, come rain or shine, bull market or bear.

Dollar-cost averaging in a broad index fund doesn't guarantee you'll make money over time. It doesn't guarantee a comfortable retirement, college for your kids, or a spot on the Forbes list of billionaires. But it guarantees that you'll own a slice of the global economy, purchased at an average price that is impervious to market volatility, and with a rock-bottom management fee. It also guarantees -- a mathematical certainty, in fact -- that you will do better than a slight majority of investors over time. That's the beauty of indexing -- and something you're not likely to achieve with mutual funds.

Fool contributor Morgan Housel owns shares of VTI, Exxon, Microsoft, and Chevron. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of International Business Machines and Microsoft. The Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of Apple, ExxonMobil, Chevron, and Microsoft, as well as creating bull call spread positions in Apple and Microsoft. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (14) | Recommend This Article (28)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 25, 2012, at 5:05 PM, Ravi786 wrote:

    I disagree with the index fund concept. It assumes that the market is rational which is flawed to begin. If you plan to be in the stock market, it is better to pick undervalued stocks that pay dividend and you can comfortably beat the index. I have been doing this and so far it is successful. Select companies that have (1) High ROA (2) low PE and PB (3) high yield compared to the broad market.

    This strategy worked in beating the index for the last 7 years. Do you have any comments that this strategy will fail.

  • Report this Comment On May 28, 2012, at 4:43 PM, beaurat wrote:

    Please share the "eight have bested the S&P 500 every year for the past decade. Seriously. Eight."

  • Report this Comment On May 29, 2012, at 9:53 AM, Greygoose1 wrote:

    I concur..Show us the 8 funds and what their fees are..

  • Report this Comment On May 29, 2012, at 4:48 PM, Peterabit wrote:

    Yes, I'm sure there's more fools waiting to hear.

  • Report this Comment On May 29, 2012, at 4:51 PM, Peterabit wrote:

    To prev. comment, I should say ( us fools ) waiting to hear.

  • Report this Comment On May 29, 2012, at 5:50 PM, GregKS wrote:

    Ravi,

    As a "Boglehead" I have to disagree. The market is rational, and to think anyone can second-guess it is extremely arrogant. Anyone who invests in the market for an extended period will eventually regress to the norm. Low PE and high yield only go so far. Think GM in 2006-2007. You can claim index beating results for 7 years, but that is a blink of the eye in truly long term investing. How many active mutual fund managers can claim market beating results over a 20 year period? Maybe 5-10, and you would have to had chosen them out of 6,000 mutual funds available then.

    Greg

  • Report this Comment On May 30, 2012, at 12:38 PM, Ravi786 wrote:

    Greg,

    I can understand where you are coming from but I respectfully disagree. Jack Bogle was making the case that instead of hiring a mutual fund manager, you can do better by indexing. However he never made the case that it is also better than individual stock picking. If you pick stocks by yourself, you can do much better than the index and mutual fund managers. Mutual fund managers follow the herd while charging money in fees. Everybody who knows about investing can do much better by picking stocks by themselves.

  • Report this Comment On June 01, 2012, at 3:27 PM, GregKS wrote:

    Ravi,

    We may have to agree to disagree. I remember studies comparing professional money managers' stock picking results to choosing stocks by throwing darts at a New York Times financial page. The results were close, but in the end the dart throwers won. With those results, how can an average investor do better than all of those professionals with their MBAs, unless they use darts?

    I don't think it is fair to say that mutual fund managers follow the herd, so much as follow the fund prospectus. After all, there are only so many stocks a manager can pick for a large cap (or pick your favorite sector) fund and still follow the prospectus. Most funds eventually revert to the norm. Berkshire Hathaway and Fairholm Fund seem to be doing that now. Contra appears to be an exception that proves the rule.

    "Everybody who knows about investing can do much better by picking stocks by themselves."

    If this were true, everybody would be making money in the market, but actually only half the people can pick the winners while the other half can't.

    "However he never made the case that it is also better than individual stock picking."

    This was the precise point Jack Bogle was making. He maintains that it is more important to have the right asset balance rather than the right assets.

    Greg

  • Report this Comment On June 04, 2012, at 1:59 PM, Ravi786 wrote:

    Greg,

    How can you say that Berkshire Hathaway is reverting to mean ? Please do not look at stock price which is subjected to various factors. Look at the earnings which is on steady trajectory increase. They are accumulating so much cash that they can do a price support of their stock if they want.

    The point that I am trying to make is, in any given market environment, there are always undervalued companies that pay dividend and it is better to go with them than going with plain index fund. If you do that, you always avoid companies like facebook, google etc which are high valuation and can carry more risk going forward.

    Do you agree that it is better to invest in Vanguard value ETF than investing in vanguard total stock market index ETF ?

    If yes, then I am going the extra step of saying it is better to invest in value and dividend paying companies.

    The only to do that is if you pick individual stocks because they do not come in fund or etf wrappers.

  • Report this Comment On June 05, 2012, at 12:12 AM, bwwolf wrote:

    When are we gonna see these what the "mystery" 8 funds are?

  • Report this Comment On June 08, 2012, at 12:33 AM, GregKS wrote:

    Ravi,

    I can only look at BH stock price because that is what is available to investors, and that stock price has not kept pace with the overall market for the last several years. That is reverting to the mean.

    Of course there are undervalued companies paying dividends. Identifying them is the problem. There are a lot of "undervalued" companies that are undervalued for a reason. GM was paying a fantastic dividend just before it went bankrupt.

    "Do you agree that it is better to invest in Vanguard value ETF than investing in vanguard total stock market index ETF ?"

    No, because a value ETF will perform better in a down market than a Total Stock Market ETF, while the TSM ETF will perform better in an up market because of its growth component. Historically there are more up markets than down. Over the long term, "buy the market".

    Buying a dividend value stock would be the right thing to do for someone wanting to minimize volatility and secure income, but for someone (decades from retirement) wanting to maximize growth, a total stock market fund/etf would be the best way to do that. If this was not true, then TSM index funds/etfs would not outperform 78% or the actively managed funds. And finally, those 22% of the funds keep changing.

    "The only to do that is if you pick individual stocks because they do not come in fund or etf wrappers."

    The preceding paragraph answers this, because every fund ultimately picks each stock one at a time. And fails over 78% of the time

    Greg

  • Report this Comment On June 08, 2012, at 12:39 AM, GregKS wrote:

    Ravi,

    I forgot, does BH pay a dividend?

    Greg

  • Report this Comment On June 18, 2012, at 4:05 PM, Ravi786 wrote:

    Greg,

    BH does not pay a dividend.

    Let me ask you - if all the rest of the investors jump off the cliff, will you jump with them too ?

    By investing in the index fund, that is what you are doing.

    I am taking this simple approach and please correct me if I am wrong anywhere

    what makes a good investable company ?

    (1) The company should be efficient

    (2) It should be cheap

    (3) It respects its shareholders

    (1) is judged by ROA - the higher the better. It just shows that the company is maximizing return on whatever assetts it has

    (2) lower PE and PB ratios

    (3) should pay a dividend.

    If you run the screen, companies show up that are beaten up very much by stock market predicting that there is no future for these companies.

    My logic is nobody can predict the future but you do not lose money any further by investing in these companies. However there can be an upside to the companies prospects.

    My current top 10 picks are

    -Telefonica Brasil S. Telecom Services

    -Telecom Argentina SA Telecom Services

    -USA Mobility, Inc. Telecom Services

    -Vanguard Natural Res Oil & Gas E&P

    -Vale SA ADR Industrial Metals & Minerals

    -Communications Systems Equipment (JCS)

    -Ark Restaurants Corp Restaurants

    -Mind C.T.I., Ltd. Information Technology Services

    -SK Telecom Co., Ltd. Telecom Services

    -Safe Bulkers, Inc. Shipping & Ports

    You might shudder investing in these companies but I am not.

  • Report this Comment On June 21, 2012, at 6:19 PM, GregKS wrote:

    Ravi,

    Unless you know precisely when to get out of the market and into bonds, you are going over the cliff with the rest of us. History shows people do not get out of the market until they can not bear any further losses, usually at the bottom of the market. Then they wait for the market to recover, missing the first 20-40% of the jump. So, to be a market timer, one has to know when to sell, and more importantly, when to buy. After reading a gazillion of these financial articles, that is a very rare trait.

    The same can be said about market segments which sometimes move counter to the market. Again, one needs to know when a particular segment is going to outperform the market and get into it before it does, and get out of those segments that under perform before they drop. Again, a very rare trait.

    Yes you can lose all of your investment if there is a reason for low prices, even if they pay a dividend, are kind to their shareholders, have low p/e p/b, etc.

    On the positive side, yes I shudder at your choices.

    Greg

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