Anyone who owns a mutual fund knows the pain of opening up a statement only to find out that while the market was up, their mutual fund was down.
There are generally two reasons why a mutual fund will go in the wrong direction vs. the market – the decisions made by the mutual fund manager and the fees charged.
It is well-known that, on average, the performance of every mutual fund in any particular sector will average out to the overall sector’s performance – before fees. This is called the ‘zero sum game’ – every time there is a winner, there is also a loser. Most investors believe (or hope) that they are picking winning funds, when in fact they may as well flip a coin.
It’s actually worse than that. Only about 1 in 10 mutual funds is able to keep up with the overall market in any given 5 year period. Check out the SPIVA reports that come out every 6 months and you’ll start to see how bad a deal mutual funds are.
And not surprisingly, it has also been proven that there is an inverse relationship between fund expenses and fund performance. In a study by Financial Research Corporation, it was found that a fund’s expense ratio was the most reliable predictor of its future performance, with low-cost funds delivering above-average performances in all of the time periods examined.
When it comes to fees, there are three categories of funds to choose from: Active mutual funds with average fees of 2.22%, Passive index funds with average fees of 0.85% and Exchange-traded funds with average fees of 0.15%. These last two categories are both considered passive or index-linked strategies.
So, what is an investor to do if they know that fees are an important driver of performance and picking mutual funds based on past performance is no better than putting all your money on black at the casino?
Warren Buffett – arguably the most successful investor in our era – has stated on many occasions: “The average investor should do nothing but put their long term funds into a low cost index fund.” In fact, Buffett’s instructions, as laid out in his will, are as follows: “Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. I believe the trust’s long term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”
Buffett effectively argues that it’s wiser to invest in a boring index fund than it is to invest with people who try to beat the market.
Jack Bogle, the founder and now retired CEO of Vanguard Group, made a convincing case for passive investing (i.e. investing in an index fund) in the Financial Analysts Journal. He argued that even if the active fund manager is able to match the performance of an index fund, tracking something like the S&P 500, the investor would still get crushed by fees.
In his study, over a 40-year period, the passive fund investor would pocket an average annual return of 6.6% versus the active fund manager who would pocket just 3.9%.
So, what should you do when your next mutual fund statement arrives and you wonder why your performance is lagging the market indices? First, don’t be surprised. Second, start educating yourself on the benefits of passive investing (also called index investing or couch potato investing). And over time consider ‘making the switch’. Your retired self may just thank you one day.