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, Reynolds Blue Chip Growth fund (RBCGX), one of the top performers recently with a 42% gain in 2009 and 15% so far in 2010:

Source: Morningstar; holdings as of Oct. 31.

Perhaps we can get a better idea of fund managers' best ideas if we know their investing philosophy. According to a recent U.S. News & World Report article, manager and founder Frederick Reynolds likes "to buy blue chip companies with capitalizations above $1 billion that have proven their ability to grow earnings at rates at or above 10 percent."

To get a feel for what's happening with his top 10 holdings, I plugged those numbers into the table above. As the inconsistent earnings growth rates illustrate, there is obviously a lot more to his investing philosophy than just a couple of simple sentences. In fact, the article points out that Reynolds has a quick turnover rate, "selling out of the market when he predicts a downturn and buying back in when stocks are cheap."

That makes it doubly tough to tell what his favorites are. Is Apple 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 his largest holding. Perhaps Reynolds has another great idea now, and he's just starting to accumulate shares -- and selling off Apple 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.

Our Million Dollar Portfolio was built specifically to select the "best of the best" from across the Motley Fool universe of stocks. Advisor Ron Gross is free to pick and choose from each newsletter's Best Buys Now list, or any other recommended stock. Million Dollar Portfolio is opening its doors again to new members. If you'd like to learn more, just enter your email address in the box below.