Form Follows Function

by Harry Jones

(July 9, 1999) -- We bought the ugliest riding lawnmower on the face of the planet. It is not sleek. Not a pretty color. It's brown. Not shiny. It's flat paint. It's not anything that looks good. At all. But it cuts grass closer than any sheep ever could.

The Problems with Mutual Funds

by Jeff Fischer (TMF Jeff)

So many factors are stacked against managed mutual funds that it is surprising that any, let alone 10% of them, can top the passive S&P 500 index fund over periods of time greater than five to ten years.

We have discussed many of the disadvantages of managed mutual funds, including annual management fees, higher taxes and chronic underperformance, but we haven't expounded on precisely why managed funds perform so poorly (beyond the reasons just stated) other than to say that fund managers trade too frequently. There are many other elements that are inherently involved in the mutual fund business that make underperformance endemic rather than the exception.

Following are a handful of "must dos" in the managed mutual fund business that all but automatically lead to underperformance.

1) Mutual Funds Must Hold Cash

Between 5% to 15% of a managed mutual fund's assets are kept in typically market-underperforming money market securities, commonly called "cash." A money market account might return 5% to 6% annually, while over the past four years the S&P 500 has averaged over 20% annually. The past four years, $10,000 in a money market account grew to about $12,388, while $10,000 invested in the S&P 500 grew to over $21,435 -- nearly twice as much.

Managed mutual funds hold cash in order to meet liquidation demands. Every day up to hundreds of owners (depending on a fund's size) sell from the fund and their cash must be delivered. Rather than be forced to sell holdings all the time to meet cash demands, cash is almost always kept on the sidelines. These funds also hold extra cash when managers expect the stock market to decline. They're wrong 50% of the time, or even more, as performance figures indicate.

2) More Cash Must Almost Always be Raised in a Down Market, Hurting Everyone in the Mutual Fund

Even if you're a long-term investor and you hold your mutual funds during down market periods, you are most likely getting hurt by a larger percentage than the market's decline every time.


Because your fellow mutual fund owners are, on average, not as stalwart as you. Many of them do not even live up to the definition of "investor," per se. Instead of being long-term owners, they are reactionaries. They buy when shares are rising, and they panic and sell at the worst times, when stocks are declining or, typically, after they have already significantly declined. Because when people finally "can't take the pain any longer," they sell. Boom! That means mutual fund shares are redeemed at or near the market bottom.

To meet the cash demands of selling shareholders, mutual funds are forced to sell more stock at the absolute worst market times, hurting the performance of everyone invested in the fund. So, even if you're a long-term buy and hold investor, you're often penalized with poorer returns in a managed mutual fund because many investors are irrational sellers and they drag down the performance of the entire fund.

3) Mutual Funds Can Be Harmed by High Cash Inflow and by Success

The near-opposite of the above can be just as damaging: too much cash. A successful mutual fund will attract attention. Within months, a mutual fund of a few hundred million dollars could balloon into a fund of a few billion dollars or more -- all of it new cash to invest. This usually presents a new challenge for fund managers, but even if managing billions isn't a new experience, it is always difficult to invest that much money and beat the market.

Mutual funds are in a Catch-22. If they begin to succeed, odds are stacked against them that market-beating success can't continue. The influx of new cash makes beating the market increasingly more difficult. And even if a fund is closed to new investors (which funds are hesitant to do, for obvious business reasons), a strong performance can cause a fund to grow so large it becomes unwieldy and its performance suffers.

In this case, an investor often needs to sell from the giant, now slow-moving fund, pay taxes, and then invest elsewhere to hope to match or beat the market again. It would have been much easier and cheaper to match the market from the start with the S&P 500 index fund, or SPY shares.

Next week, at least three more reasons why managed mutual funds are inherently poised to underperform the stock market averages.

Fool on!

 Recent Harry Jones Portfolio Headlines
  08/26/99  Is it a Nifty 500? Part II
  08/19/99  Is it a Nifty 500? Part I
  08/12/99  Illuminating Index Funds, Part Two
  08/05/99  Illuminating Index Funds
  07/29/99  The Foolishness of Index Funds
Harry Jones Portfolio Archives »  

07/08/99 Close

Stock Change Close SPY + 7/64 139.67
Day Month Year History HARRY +0.08% 1.95% 9.44% 9.44% S&P: -0.10% 1.58% 14.02% 14.02% NASDAQ: +1.05% 3.21% 26.41% 26.41% Rec'd # Security In At Now Change 1/4/99 16 S&P Depos 127.63 139.67 9.44% Rec'd # Security In At Value Change 1/4/99 16 S&P Depos 2042.00 2234.75 $192.75 CASH $0.00 TOTAL $2234.75 Yesterday Today Change S&P Depos 139.56 139.67 SPY + 7/64


FoolWatch -- It's what's going on at the Fool today.

Are you a Foolish investor?
The Motley Fool Recommends...
Industry Snapshot
New format! A stock idea, industry overview, top players, and financials -- every two weeks! Get more info or order.

Foolish Eight Stock Screen
Here at Last! Foolish Eight Stock Screen. Get more info or order.

Shop FoolMart!