Like 'em or not, mutual funds are big business. In August, the combined assets of the nation's mutual funds reached $9.6 trillion. With the Pension Protection Act making retirement saving more of a do-it-yourself endeavor, that figure will only increase.

That fact, together with a recent article in TheWashington Post, made us wonder: Which is the better hypothetical long-term investment, owning stock mutual funds or the common stocks of the companies that run those mutual funds?

Dump your duds
If you're in an "average" fund, you probably shouldn't invest another penny. Remember that approximately 75% of actively managed funds trail their benchmarks over time -- a sad reality that studies have proved over and over again.

A study by Elton, Gruber, Hlavka, and Das showed that from 1965 to 1984, funds underperformed their benchmarks by 1.6 percentage points. And a study by Carhart of every fund that existed between 1961 and 1993 showed underperformance of 1.8 percentage points.

And this isn't a coincidence. The return of the average actively managed fund tends to trail the market by that fund's expense ratio.

And the winner is .
Now let's compare that return with what you could earn investing in the companies that run the funds:


10-Year Annualized Return

Affiliated Managers Group (NYSE:AMG)


Citigroup (NYSE:C)


Franklin Resources (NYSE:BEN)


Legg Mason (NYSE:LM)


Merrill Lynch (NYSE:MER)


Morgan Stanley (NYSE:MS)


T. Rowe Price (NASDAQ:TROW)


S&P 500


*Since November 1997

While this isn't a perfect comparison -- many of these companies do more than simply manage funds -- the data are nonetheless compelling. Very compelling. If we assume that the average mutual fund does a little bit worse than the S&P 500 average, then the folks who own the companies that run the mutual funds are doing a lot better than the folks who own the mutual funds.

The trend has continued this year. According to the article in the Post, "An index of 20 fund-manager stocks rose 20.8% from Jan. 1 through Oct. 13, more than double the 10.2% advance of the average stock-mutual fund tracked by Bloomberg."

That, folks, is troubling
So what can we do about it? Well, the way we see it, investors have three options to eliminate subpar returns from actively managed funds:

  1. Move into index funds.
  2. Commit to fund investing and work hard to find the 25% of funds that do beat the market and earn great returns.
  3. Start picking your own stocks.

You can, of course, choose any of these three options. But if you have the time, the most important thing is to learn to pick your own stocks. You may beat the market -- because you don't have management fees dragging you down. And you may find the above-listed companies worthy of your dollars.

Indeed, Affiliated Managers Group was twice recommended in our Stock Advisor newsletter service in 2002. Fool co-founder Tom Gardner singled it out because it was run efficiently, managed by smart people, and trading at an appetizing discount.

When you're picking stocks on your own, look for those characteristics in tandem. If you need a cheat sheet to get started, you can get two top picks from Tom and his brother David delivered straight to your inbox, free of charge. Click here to read up on their two latest picks -- and get started beating the pros at their own game.

Brian Richards and Tim Hanson once tried to beat the pros at their own game, but they lost, because the game was eating hot dogs as fast as you can in front of a live audience. Neither Brian nor Tim owns shares of any company mentioned in this article. The Fool has a disclosure policy.