Rule Maker Portfolio
Funds vs. Makers
The Three F's....

By Tom Gardner

Editor's note: The following is an encore presentation of one of Tom's most popular columns. It was originally published on January 29, 1999.

ALEXANDRIA, VA (Sept. 17, 1999) -- In Fooldom, you'll often hear us talking about the managed fund industry's consistent and significant underperformance of the market's average return each year. Sometimes we may even sound like a broken record. The general message remains the same: Index funds provide the lowest-cost alternative for individual investors. Index funds consistently beat managed funds, before and after costs are factored in. And yet, even though the index fund is the fastest-growing segment of the mutual fund industry, investors continue to dump billions of dollars into managed funds.

Now, while I think this is a bad idea, it does contribute to the general pricing inefficiency in the marketplace that allows Foolish Rule-Making investors to profit. Ideally, Arthur Levitt of the SEC would come out with a warning about managed fund performance and fees -- instead of contributing to the rag on the growth in discount brokering. But it also is kind of nice that he and others are ignoring this issue. It's part of the reason we're nearly 15 percentage points ahead of the S&P 500 since our launch last February.

But why do managed funds underperform? Here are my Three F's of mutual fund submediocrity. Do you agree?

1. Fees

We'll start with the costs associated with owning mutual funds. Today, the average managed fund carries a 1.75% yearly expense ratio. Compared to the 0.20% annual expense fees of Vanguard's S&P 500 Index Fund, each year most funds start at a 1.55% disadvantage to the norm.

Fees are the primary reason that the index fund beats the rest of its industry, year after year.

Now, if you don't think 1.55% is a meaningful difference, consider that a $20,000 portfolio earning 9.45% per year instead of 11% per year will lag farther and farther behind the norm with time (the dismal side of compound interest is that the rate of growth matters a great deal). In fact, the 1.55% distance between the two types of funds marks a difference in hundreds of thousands of dollars over a lifetime. Take a look at some numbers: 

$20,000 Invested for the Long Haul: 

           20 years    40 years      60 years
at 9.45%   $122,000    $741,000      $4.5 million
at 11.00%  $161,000    $1.3 million  $10.5 million
There's the difference, a difference of more than $500,000 over a 40-year period. And where did that half million disappear to? The mutual fund family.

The average fund investor today is paying tens of thousands of dollars to mutual funds in order that they might receive subpar investment returns. Wacky.

2. Focus

But fees aren't the only obstruction for mutual fund investors. The focus of the typical fund management company is far less on performance than it is on corporate profit. The largest managed fund families spend millions of dollars each year to promote their products, placing their strongest emphasis as an organization away from money management and toward marketing.

One need look no farther than the standard fund advertisements, championing their many-star funds that nevertheless have done worse than average over the recent 3- and 5-year periods. The ads work! And so the $5.5 trillion mutual fund marketplace is riding an economic model that rewards great marketing far more than great investing.

Consider these numbers. A mutual fund that just invested its way into a larger asset base would, at a rate of 10% growth, double in size every 7.5 years. If, instead, that same fund advertised heavily, ringing in a slew of new investors, they could likely double their asset base in 3-5 years (if that!).

That difference is what has most fund families concentrating far more intensely on how they market themselves than on how they manage their services.

3. Frenetic Behavior

It doesn't get any better as we drive into category three.

The "turnover ratio" at the average mutual fund rings in between 70% and 80% each year. This means that the normal fund manager sells out three of four positions every 12 months. While this activity earns the fund free research from its brokerage-firm partner (and earns the brokerage firm payment for order flow from the major exchanges), all it really provides the investor with is a slew of taxable gains at the end of each year.

Let's put that in context. The Rule Maker Portfolio pays little attention to the taxman in April -- no matter how much our stocks have appreciated. Provided we haven't sold anything -- and we plan to hold our companies for 10 years or longer, at least -- we only have to pay taxes on our dividends and, overall, the dividends in this account are minimal (we'd love it if our companies eliminated them altogether).

The same is not true for the average fund investor who has to factor in the tax consequences of the 70-80% turnover at their fund. Yes, the frenetic behavior of fund managers earns them a back-scratching relationship with their brokerage partner. But it socks the investor in the chops.

Match heavy taxes with high fees and market underperformance, and you have a one-two-three punch that has many, many investors earning literally hundreds of thousands of dollars less in their lifetime than they would with just the market's average return.

Conclusion

The reason that $5.5 trillion has been invested into managed funds, bringing investors far less than just the average, is the small-f foolishness of the average 401(k) investor, corporate pension investor, small investor, etc. The media and the SEC, and other potentially educational forces in the marketplace, have largely failed to communicate this message to investors.

Just one of the values of a network of Fools, I guess.

Have a great weekend.

Tom Gardner, Fool