Every year or so, somebody freshens up a study that shows active mutual fund managers underperform passive investing, usually in the form of an ETF of the category benchmark. In plain English: Buying the ETF instead of the mutual fund of the same type will generate higher returns for you over the long-run, and often even the short term. So, why are active investment managers so bad?
Mutual Funds Cost Money to Run
Mutual funds are not charities. They have expenses they need to cover. Expenses include everything from offices to high paid analysts, to traders to execute the trades, to all of the electronics and equipment it takes to monitor and use all the information in the trading world. Oh yes, then there is the matter of profit.
These expenses are disclosed to all investors in the required information made available to any investor in the prospectus and on most trading and investment research platforms.
Pulled quickly and semi-random is the Dodge & Cox Stock Fund, a large U.S. stock mutual fund. You will notice that compared to the S&P 500 index listed below, our well-respected Morningstar 5-star fund returns less than the S&P 500 over any time period. However, you will notice that the fund does better than the Russell 1000 Value in the same period. This is why mutual funds strongly suggest at every turn that they be compared with an index of their choice.
Do Active Managers Really Lose to the Index?
In most cases active managers lose to the index because of expenses. You can find the mutual fund expenses in research listed as an Expense Ratio. This is the percentage the company who runs the fund will take from your investment. Too high of expenses and the performance of the fund can’t overcome the drag of the fees. That is why to always search for the lowest cost option that meets your needs.
As shown above some active fund managers manage to outperform the index. Typically, they either have one or two holdings that disproportionately well (like AOL during the internet bubble years) along with low expense ratios.
What about the others?
There are thousands of mutual funds out there. Many of them you have never heard of, and never will. Many of them do not do well. They are quickly merged into other funds and disappeared. After all, who would buy a mutual fund with terrible returns? This causes survivorship bias.
Survivorship bias occurs because poor performing funds are eliminated from the pool, leaving only good funds behind. The terrible performance of the XYZ fund for 10 years goes unreported the day it gets merged into the ABC fund that has a much better record of accomplishment over those 10 years. That is little solace to the poor investors in the XYX fund before the merger.
When you include thousands of mutual funds, passive management in the form of ETFs and index funds always wins, often for no reason other than expenses. So, why do other funds exist?
Hope springs eternal for investors who insist that some investment managers do better than others and that some mutual funds are worth having. In addition, there are reasons to own mutual funds unrelated to overall performance, such as better risk management, or improved tax benefits.
Either way, as a former financial planner I can tell you that the most important thing is to invest in almost anything and then keep investing in it. That is how people end up with $400,000 401(k) balances after a middle-class career. They started their 401(k) contributions because “they were supposed to,” and then never touched it until they retired. They contributed 8% into whatever funds were in the 401k and never stopped and now they have a big enough nest egg to have options.
Does that mean you shouldn’t try to find mutual funds and other investments that work for your investment objectives? Absolutely not. Does it mean you should take a sharp look at expenses and beyond last year’s returns? Absolutely yes.
About the Author
By Brian Nelson – Brian is a former Certified Financial Planner and financial advisor. He writes for Finance Gourmet and other financial publications. The material provided on this website is for informational use only and is not intended for financial or investment advice. At the time of publication, Mr. Nelson did not own any securities mentioned above, however, that may change at any time without notice. Consult with your own financial professional when making decisions regarding your financial or investment options.