The unfortunate and mostly unreported truth about stock mutual funds is that they are simply not a good investment (the same holds true of bonds funds in our opinion but for different reasons, the focus in this article is on stock funds). Stock mutual funds consistently underperform their index benchmarks which means that many thousands of highly educated and highly paid stock pickers cannot beat a simple investment in an index fund. Let’s examine the data.
Numerous studies, such as those conducted by S&P and Vanguard, have shown that stock mutual funds regularly underperform – this is true every single year and over the long term. According to one study, for the 15 year period ending mid-2013, 74% of stock funds underperformed. The results are even worse when adjusting for the fact that many mutual funds close due to poor performance. Vanguard’s study adjusted for these closed funds and showed that the long term underperformance is closer to 80%. In any single year the performance is slightly better but still poor every year measured. For 2013, 64% of mutual funds underperformed their index benchmarks. In 2012 the figure was 66%, and in 2011 a horrible 84% underperformed. Every category of stock mutual fund underperformed.
What about a strategy of sticking to the highest performing mutual funds, after all one can identify the 20-30% of funds that did outperform in the past year or several years? While it is true that some mutual funds do show outperformance over a 1 to 5 year period of time, almost all eventually fall behind their benchmarks. S&P’s study showed that of the 692 top quartile funds in 2011, only 7% remained in the top quartile in 2013 – which means that 93% of top funds in 2011 could not remain in the top quarter of performance two years later. In fact, only about 6% of funds were able to remain in the top quartile over a five year period of time, which S&P concluded was no different than what would be suggested by randomness! Vanguard’s study of 5,763 stock funds showed similar stark results. Vanguard conclude that “the results for U.S. investors in U.S. equity funds do not appear to be significantly different from random.” This means that blind luck can explain the strong performance of certain mutual funds over the long term – and trying to pick which ones will be the outperformers is virtually impossible, since last year’s hot fund is more likely than not to be this year’s laggard.
(Relevant side story: There apparently used to be sales technique employed by unscrupulous stock brokers that highlights the concept that randomness will results in some fantastic winners. The brokers would call 100 prospects about a particular stock. To half they recommended buying the stock and the other half to sell. Of the 50 prospects that received the correct prediction, the brokers would do the same thing with a new stock pick, reducing the “always correct” group to 25. The process was done a third time, resulting in 12 individuals who received the right stock pick three times in a row. The broker would then call to brag about their stock picking and that they should open an account with them.)
Fidelity actually offers a group of stock mutual funds (ironically) called “Stock Selector” which implies that a team of highly experienced investment experts were carefully “selecting” stocks that would outperform their benchmarks. Remarkably, 3 of the 4 Selector funds sharply underperformed over the life of the fund, and one managed to exceed slightly (but yet has lagged in the last three years).
While hedge funds are a topic for another article, one might think that the stock pickers at hedge funds are a notch above those at mutual funds – but the results are the same, consistent long term underperformance. 2013 was a particularly bad year for hedge funds as every single category underperformed the S&P 500. The average equity hedge fund returned 18% in 2013 versus 32% for the S&P 500. Since 1994, the average hedge fund returned 8.7% per annum versus 9.2% for the S&P 500. While there may be a few highly unusual hedge fund managers that can consistently outperform, there is a good argument that this can be explained by randomness (i.e. of the thousands of hedge funds, a certain percentage will outperform simply by chance). A book called Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Taleb offers a fascinating analysis of this phenomenon. Warren Buffet is obviously known for his investment skill and over the long run Berkshire Hathaway stock has handily beat the S&P 500 – but the secret is out, and over the last five years the stock has lagged the index. Buffet’s company is so large that it basically mirrors the index. The trick is to find the next Buffet when still small and unknown.
The bottom line is that with all the information available, it’s not an easy task to identify mispriced stocks and outperform the market. The stock price already takes into account all known information. Super hard work and smarts seems like the key to success but the collective wisdom and market actions of millions of shares traded each day blunts the individual effort. In 2008, Warren Buffet famously bet $1 million for charity that an S&P index fund would outperform five hedge funds hand-picked by Ted Seides, a prominent money manager. As of January 2013, five years into the bet (a more recent update is not available), the S&P fund is up by 8.7% while the five funds are only up by a meager 0.13% or basically break even. This confirms Buffet’s often stated belief that over the long term, “experts” will underperform the overall stock market, especially after adjusting for expenses.
Why the mutual fund industry persists is a broader question, but much of it is due to heavy marketing backed by an enormously profitable industry and investors not knowing the facts. Boredom also play a role in my view; many investors are not content with index funds, they want action, and picking stocks and chasing hot mutual funds is far more exciting. Index funds have slowly infiltrated the market, but comprise only 17% of mutual fund assets. The industry does not really want to promote an investment choice with much lower fees. (Except for Vanguard which actively promotes indexing and is the author of major studies on indexing).
Downtown Investment Advisory (DIA) does not recommend mutual funds and recommends that investors reassess their portfolios if heavily focused on third party mutual funds. If you have an advisor that places you in mutual funds, why pay an investment advisor a fee to then hire another third party advisor (i.e. the mutual fund manager) to invest? In these cases, investor fees can approach 2% of assets, which is much too high (the mutual fund fees are embedded in the mutual fund returns). Instead of mutual funds, DIA recommends Index Fund ETFs. These index funds are virtually assured of beating mutual fund returns and at a much lower cost. By definition, no one picks stocks for an index fund, it follows a pre-set formula, such as the top 500 companies by size (the S&P 500). While the S&P 500 is the most commonly known index fund and can be a good choice for many portfolios, there are many Index ETFs available that can be customized to create various portfolios, more aggressive or less aggressive, more income focused or more growth focused.
Note that this article was written to provide information and education, and is not intended to be considered investment advice, which can only be provided by DIA following a consultation and execution of an Investment Advisory Contract.