Invest $10 Trillion Dollars And Get A Below Average Return? Why Most Mutual Funds Underperform

Over 50 million U.S. households – almost one in two – own mutual funds today.

The U.S. mutual fund market, with over $10 trillion in assets under management, remains the largest in the world, accounting for nearly half of the mutual fund assets worldwide. Investments into mutual funds have poured in at a staggering pace over the past fifteen years. Cash inflows have grown steadily from $156 billion in 1992 to almost $500 billion today.

Clearly mutual funds are the place to be, or are they?

Let’s look at the scoreboard.

About 80 percent of mutual funds fail to beat the average return of the Standard & Poor’s 500 Index. This is not a new trend, rather it is an alarming statistic that has been occurring for years. What makes this more sobering is that the mutual fund industry itself chose the S&P 500 Index as its comparison benchmark. Adding insult to injury, funds have collected millions in fees from their investors over this time period, regardless of performance. Not music to the ears.

Why Have So Many Invested, Just To Get Sub-Par Returns?

So, why have so many invested their hard-earned money in mutual funds? First of all, mutual funds employ professional analysts who devote considerable time to the study of stocks. Who doesn’t want experts on their side?

Then there is the often-mentioned advantage of diversification and its reported by-product, safety. Risk is reduced by spreading your investment dollars over many stocks, which has the effect of smoothing-out the market’s fluctuations. Low fluctuation sounds good.

Mutual funds also offer smaller investors an opportunity to invest in the market. Rather than having to purchase 100 shares of a single stock, small investors can purchase a single share of a mutual fund and effectively own a portion of hundreds of companies.

But perhaps the most compelling reason is simplicity. With mutual funds, the individual investor does not have to spend any of their free time studying financial reports or weighing the merits of individual companies in a quest to find winning stocks. Mutual funds do all the heavy lifting for the individual. Also, the mutual fund industry offers an easy-to-understand investment menu to the public. With handy fund classifications such as “Growth” and “Income”, it’s no wonder mutual funds have become a very popular form of investing.

But with so much going for mutual funds, why do most perform so badly?

There are three primary reasons for mutual funds under performing the market:

Short-term bias

Fund managers compare their fund’s performance on a quarterly basis to the S&P 500 Index. Obsessing over short-term results, managers often perform unnatural acts just to beat the Index. Many engage in rampant buying and selling of stocks in the short-term to prop up year-end performance metrics.

Need proof?

The average annual turnover rate of mutual funds is an astonishing 50 percent. This high turnover prohibits the funds from letting their winners run, effectively cutting short the lives of those stocks that would ultimately produce high returns for shareholders.

Compounding this further, many funds mandate that their managers fully invest all available cash at all times, regardless of market conditions. So much for buying low and selling high.

Not all your dollars are working for you

High turnover translates into high transaction costs. Mutual funds charge an average of 2.5% in commissions and expenses. Two and a half percentage points may not sound like much, but when put into perspective it’s significant. Let’s say your fund generated a 10% return. That 2.5% of expenses would effectively lower your return by 25 basis points, to 7.5%. And we haven’t yet considered taxes. Given their high turnover, mutual funds generate significant short-term capital gains taxes which are passed directly to shareholders every year. Every dollar spent paying taxes is one less dollar you have to invest.

“Diworse”ification

This may come as a shock to some but being too diversified is a bad thing. Blasphemy you say! Most stock funds own shares in several hundred companies. They do this to eliminate the up-and-down movement of individual stocks as noted above. Managers know that investors don’t want to see a lot of volatility in the fund’s share price. However, this serenity comes at a price. By holding so many companies, the funds essentially become the index that they are trying to beat. For example, if you own a single share in each of the 500 companies that make up the S&P 500 Index, what are the odds that you will beat the Index? Exactly none. At that point, you are the index.

So what is an individual investor to do?

This article is not meant as an indictment against mutual funds. There are several funds out there that do well and do so consistently. The challenge for investors is to find these gems. Not an easy task with over 9,000 funds on the market and today’s stars are many times tomorrow’s losers.

If you are drawn to some of the attributes of funds such as diversification, you may want to consider index funds. These funds are structured to mirror an index. Turnover is low and there is very little required in the way of management, so expenses are low. The result: performance that matches the index. Index funds are a great way to get some of the attributes of mutual funds but without the overhead of traditional mutual funds that decrease returns.

But for those wanting above average returns, individual stock selection is the key. Direct stock ownership gives you distinct advantages over mutual funds. Specific stock selection allows you to avoid the over-diversification trap and to focus your funds into a handful of excellent companies.

As a smart long-term investor you also won’t suffer from high portfolio turnover which means more of your hard-earned dollars will be working for you instead of going towards commissions and taxes.

Lastly, you get to decide when to buy stocks, and equally important, when not to invest. There is no mandate requiring you to spend your cash. You can simply wait for the right investment opportunities to come to you.

However you decide to invest, take your time, do a lot of research and most important – invest wisely.

Be free. Nothing else is worth it.