We here at the Motley Fool have a long-standing bias against managed mutual funds, because managed mutual funds provide all of the risk of owning stocks, but only part of the rewards. Here's why:
There is more than $3.5 trillion in stock mutual funds. That's a huge percentage of the total money in the stock market. In fact, studies show that's exactly what the actively managed mutual fund does -- it matches the market. On average, however, mutual funds charge about 1.5 % per year in fees paid to management. Additionally, funds manage to rack up about 1% per year in costs for trading in and out of stocks.
Thus, mutual funds provide total returns of about 2.5% less per year than the stock market, reducing the market's average returns from 11% per year to about 8.5% per year. For all the screaming headlines about one year's good performance and all the television commercials about the wisdom of the people guiding them, the big check that mutual funds write to themselves with their shareholders' money makes it impossible for them to produce satisfactory results.
"Fine," you say. "I understand that most mutual funds don't beat the market, but what about the ones that have been beating the market over the last three, five or 10 years? Aren't they really what a novice investor should be choosing?"
While that's a very logical approach, it doesn't help. The vast majority of mutual funds that beat the market over any period of time fail to continue beating the market after their superior performance is discovered. There are two major reasons for this. One is that with more than 10,000 mutual funds out there, simple luck explains how most of these "winning" funds beat the market. Through sheer chance, there will always be a certain number of funds owning the right companies at the right time -- but luck runs out.
The other reason that a mutual fund's performance will turn south after a good run is that good performance tends to grab attention. This attention invariably leads to new people adding money to the mutual fund, and to a manager suddenly having to manage a lot more money than he previously had. In the words of Warren Buffett, "A fat wallet is the enemy of superior investment returns." The biggest mutual funds are less nimble than their smaller competitors. When you've got billions of dollars to invest rather than millions, a mutual fund manager has to start looking at much larger companies to buy than he otherwise would prefer.
There are a handful of funds that have posted market-beating returns over the long term. However, as explained in this article, just 20 domestic stock funds have bested the Standard & Poor's 500 over the past 10 years. Will those same 20 beat the S&P 500 over the next decade? Not likely. Which is why Fools prefer index funds -- if you can't beat the market, might as well match it.
To learn more about indexing, check out our 60-Second Guide. And for a very funny explanation of the risks of owning mutual funds written in plain English rather than the legal boilerplate that makes your eyes glaze over, check out this link.