Best Buys Now

Perhaps you've heard that roughly three-quarters of all mutual funds lose to the market over the long run. The question is why -- why do presumably smart and talented managers serve you worse than simply buying an index fund? Believe me, I've met plenty of fund managers, and the vast majority of these folks are talented and responsible and hard-working -- they're not bad stock pickers.

The best explanation I've found comes from a recent study by professors Cohen, Polk, and Silli. Their study, "Best Ideas," provides pretty convincing evidence that the rules are stacked against smart fund managers. Their few very best ideas do perform well -- beating the market and their other picks by approximately 1% to 4% per quarter (which is significant). However, the very nature of a mutual fund requires managers to pick dozens -- perhaps hundreds -- of stocks.

Who can pick 100 good stocks? No one, really ... and having to load up a fund's portfolio with a bunch of second-tier ideas seriously harms returns.

But what if ...
The knowledge that fund managers' best ideas tend to outperform might be profitable for us individual investors if we knew with certainty which stocks they most loved. One proxy for determining a fund's favorite ideas might be to look at its largest holdings. Take, for example, the famous Fidelity Magellan fund, headed up by Harry Lange:

Data from Morningstar; holdings as of Aug. 31, 2010.

Perhaps we can get a better idea of fund managers' best ideas if we know their investing philosophy. According to a Kiplinger article published not long after Lange took the helm at Magellan, he likes companies that have "a real sustainable advantage" and that own a part of an industry. He also likes shareholder friendly management that doesn't make a lot of acquisitions.

If a stock happens to be misunderstood by Wall Street and selling for a reasonable multiple, it could be "one of the top positions in the fund." In the table above, I used ROE as a proxy for strong sustainable advantage, and the P/E ratio to give us a feel for valuation.

Even with that information, it's tough to tell what Lange's favorites are. Is Applied Materials really his very best stock idea right now? We can't really know unless we bug his meeting rooms. Maybe it is, or maybe it just grew to be Magellan's largest holding. Perhaps Lange has another great idea now, and he's just starting to accumulate shares -- and selling off Applied Materials to do so. There's lag time in reporting fund holdings, and who knows which company is on top now?

You undoubtedly see the problem here: We don't want to commit our hard-earned money to a guessing game. So now you know the big reason for mutual fund mediocrity, and there's just no getting around it.

Unless ...
There's something of a silver lining in this study, however. If you're an experienced and competent investor, you can take comfort in knowing that you're not bound by the mutual fund rules. You don't have to buy dozens and dozens of companies; you can limit your investments to your very best ideas.

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This article was originally published Aug. 19, 2009. It has been updated.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Rex Moore drives on a parkway and parks on a driveway. He owns no companies mentioned in this article. Nokia is a Motley Fool Inside Value choice. Apple, MedcoHealth Solutions, and Staples are Motley Fool Stock Advisor recommendations. The Fool owns shares of Apple. The Motley Fool has a disclosure policy.