You've surely heard this before: The vast majority of managed mutual funds underperform the stock market. By “vast majority,” I mean around 75% or more, depending on the time period involved.
I just learned something new, though -- it seems that the likelihood of a managed fund outperforming the market is actually even lower than we've thought. Finance professors Laurent Barras, Olivier Scaillet, and Russ Wermers have published the results of a study in which they tried to figure out what percentage of a fund's performance is tied to luck, vs. the skill of its managers. They looked at the records of some 2,100 domestic stock funds between 1975 and 2006.
Their conclusion? If you looked in 1990 to see which managers had an edge beyond what luck would explain, you would have found about 14% with quantifiable skill. But when you look all the way up to 2006, that percentage drops to just 0.6% -- a statistically insignificant figure.
What's going on?
How can we explain this? Well, the study suggests several possible explanations: fees, hedge funds, and a more efficient market. Let's look at them, shall we?
First off, fees can indeed make a huge difference. It's hard to outperform the stock market's historic average, so even beating it by a single percentage point is respectable. But with expense ratios (annual fees) of 1.25% not unusual, that alone is a big hurdle to overcome just to keep pace with the overall market.
Fees are an interesting issue because:
- Funds need to charge them, to pay managers and keep the lights on.
- As funds grow larger, they should often be able to lower their fees, taking advantage of economies of scale. (In other words, if a fund suddenly has twice as much money to invest, that doesn't mean it has to pay twice as many managers -- its costs won't have doubled.) But they often don't.
- There's self-interest at work in fund-land. Fund companies want to make money, so they sometimes charge very high fees and sales loads, too. This provides an incentive to salespeople to sell the funds, and many investors aren't savvy enough to scrutinize the high fees.
Here’s an example of problematic fees -- the American Century Select B (ABSLX) fund charges 2% per year in annual fees, along with a deferred sales load of up to 5% if you sell shares within the first several years you own the fund. When a fund is taking so much from your investment, it’s hard for it to grow at a good clip. Indeed, the fund’s average annual return over the past five years is a paltry, market-underperforming 1.9%, despite owning some good stocks, such as MEMC Electronic Materials
Another possible reason why no mutual fund manager can beat the market is the rapid proliferation of hedge funds, which are drawing many investment pros to them as they tap the supply of available money managers. The migration is understandable, given the often lavish fees that hedge funds collect. It’s common for them to take 2% of assets each year, along with 20% of all gains.
Another explanation is a more efficient market. This may also be true, at least to some degree. Investors have been growing savvier, and have more information and resources available to them online. Many brokerages offer rich research capabilities to customers. (Find a better broker via our Broker Center.)
What to do
So what should you do, if it looks like fund managers can’t reliably outperform the market? Well, you might want to consider just aiming for the market's return, which you can get via an inexpensive index fund. Alternatively, you can carefully select individual stocks, as some may give you terrific results. Here, for example, are 10-year average annual returns for a few familiar names, via Morningstar. (Remember that the market’s average over this period was just 4.6%.)
Bed Bath & Beyond
You could also aim to find some funds that will actually outperform. One place to start is with funds with low to reasonable fees. Indeed, the researchers involved in the study I referred to earlier noted that when fees are factored out, some 10% of managers appear to have market-beating stock-picking skills.
We can help you with your fund search, as we think we’ve identified a bunch of winners whose success is due to more than luck. Take advantage of a free trial of our Motley Fool Champion Funds newsletter service today and see for yourself.
Longtime Fool contributor Selena Maranjian owns shares of Wal-Mart. Wal-Mart and Bed Bath & Beyond are Motley Fool Inside Value picks. Charles Schwab, FedEx, and Bed Bath & Beyond are Motley Fool Stock Advisor picks. The Fool owns shares of Bed Bath & Beyond. Try our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.