When I first started investing, I bought mutual funds. My rationale was that fund managers had to know more about the market than me… right?
(Eventually, I started investing in stocks on my own. The only funds I tend to buy these days are index funds, like the ones Chief Investment Strategist Alexander Green recommends in The Gone Fishin’ Portfolio.)
The 1990s were the golden age of mutual funds. Fund managers like Peter Lynch were treated like rock stars.
Mutual funds were featured prominently in investing magazines, like Money and Kiplinger.
But now their dirty little secret has come out. Year after year after year, actively managed funds underperform the market.
Want to hear a shocking statistic?
Ariadne Wealth Management recently conducted a study of Fidelity’s 136 large cap mutual funds. The number that beat the S&P 500 was staggeringly low.
Take a guess how low.
The answer is ZERO.
None of Fidelity’s large cap mutual funds beat the S&P 500. Not a single one.
Nada. Bupkis. Goose egg.
You’d think one or two might have beaten the S&P just by accident!
And keep in mind…
Fidelity’s fund managers weren’t picked out of a high school detention class. These are smart individuals with MBAs from Wharton, the University of Chicago and the like.
Yet despite those accomplishments, this study proves that the actively managed mutual fund model doesn’t work.
Sure, you may find a few superb fund managers like Lynch who deliver outperformance. But they are very hard to find. (And if you want consistent outperformance, they’re nearly impossible to find.)
Fidelity is hardly alone.
Standard & Poor’s determined that 88% of actively managed mutual funds fail to beat their benchmarks. And that underperformance comes at a price…
The expense ratio for an actively managed fund is 60 basis points – 0.6% higher than that of a passive fund (one that follows an index).
There are several reasons you will most likely underperform the market when investing in actively managed funds.
- Funds have higher expenses: As mentioned above, you’re already starting out at a 0.6% disadvantage in the average fund. In many funds, you’ll pay more than 1%. That means just to keep pace with the market, the fund needs to beat it by a considerable margin. And that’s not easy to do, because…
- Funds aren’t flexible: A mutual fund has to stick to its mandate. If it’s a large cap fund, it can’t invest in small cap stocks, and a value fund won’t buy a momentum stock, growth stock, etc. As an individual investor, you can diversify your portfolio to include a variety of market caps, sectors and strategies.
- A fund can’t buy small winners: The biggest advantage you have over a mutual fund as an individual investor is the ability to choose some small stocks that can become big winners. Multimillion-dollar mutual funds can’t invest in a small stock without strongly moving shares higher. That would impact their returns, so they mostly ignore small names. As an individual investor, you don’t have to worry about that. Your purchase of even a few thousand shares likely won’t move the market.
- Size matters in funds: Another disadvantage of mutual funds is that in order to accumulate a meaningful position in a stock, it can take days or weeks to buy enough stock. An individual investor can accomplish this in one day.
If you don’t want to pick your own stocks, the easiest thing to do is invest in an index fund. Not only will it be cheaper but also, as the statistics show, you’ll make more money.
Let someone else pay Harvard MBAs for underperformance.