Mutual Funds: Performance

The Performance of Mutual Funds

Mutual Funds

By Bill Barker

The February 1999 issue of SmartMoney Magazine saw fit to phrase the question on the minds of 1998's mutual fund investors in these words:

"How could the market be up 22% in 1998 and my returns be only half that?"

"Why, you ask, do all my mutual funds suck?"

While we Fools hesitate to endorse the crude language employed by SmartMoney, we cannot help but be enthused that such a publication is asking the right question. And so succinctly.

But it wasn't just in 1998 that investors should have been directing such epithets toward their mutual funds. For many years now the record for equity mutual funds has not been good. Though countless millions of dollars of shareholders' money is spent annually by mutual funds promoting themselves and the notion that they have "expert" stock pickers, the sad truth (or the funny truth, if you're in a laughing mood) is that the vast majority of mutual funds underperform the returns of the stock market (as represented by the S&P 500 index). Because of their excessive annual fees and poor execution, approximately 80% of mutual funds underperform the stock market's returns in a typical year. Over the past couple of years, that number has been going up, as mutual funds have been raising their fees to even higher levels.

The average actively managed stock mutual fund returns approximately 2% less per year to its shareholders than the stock market returns in general. There is currently no reason to believe that this differential will improve, or that actively managed mutual funds as a group can ever outperform the stock market's average returns. For that reason, investors who are going to invest in mutual funds rather than in individual stocks should hold a very, very, very strong bias toward investing in index funds, which invest across the board in a stock market index.

Here's a graph of the number of mutual funds that have failed, on a year-by-year basis, to match the returns of the Standard & Poor's 500 index, the most widely followed stock market benchmark.

General Equity Funds Outperformed by the S.& P.'s 500 Index
1963 - June 30, 1998
Source: John Bogle, Common Sense on Mutual Funds : New Imperatives for the Intelligent Investor, p. 119.

Yowza. That obviously isn't a great record for the actively managed mutual funds.

The costs of being in the average actively managed mutual fund over time are, put simply, very, very severe. Although 2% may not sound like that much of a differential when the market is returning roughly 20% per year as it has from 1995 through 1998, the standard returns for the stock market historically are closer to 10%. Consider whether this is severe enough for you: over 50 years, a $10,000 investment will compound to $1,170,000 at 10% returns per year, but to only $470,000 at 8% per year.

Vanguard founder John Bogle looks at these numbers and says: "[O]ur hypothetical fund investor has earned $1,170,000, donated $700,000 to the mutual fund industry, and kept the remainder of $470,000. The financial system has consumed 60% of the return, the fund investor has achieved but 40% of his earnings potential. Yet it was the investor who provided 100% of the initial capital; the industry provided none. Confronted by the issue in this way, would an intelligent investor consider this split to represent a fair shake? Merely to ask the question is to answer it: 'No.'"

What explains this differential in performance between the stock market and the mutual funds that invest in the stock market? You would think that all these sartorially splendid MBA-grad mutual fund managers who are selected daily by the Wise financial media to tell us how we should invest our money could pick some reasonable stocks every once in a while. That's their job after all, right? Nobody would want to fail in their job as much as mutual fund managers apparently do, so what's going on here? Is it because managers of mutual funds are actually bad stock-pickers? And, by the way, who's this John Bogle, and what's really so great about an index fund?

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