The Performance of Mutual Funds
By Bill Barker
The February 1999 issue of SmartMoney Magazine saw fit to phrase the
question on the minds of 1998's mutual fund investors in these words:
question on the minds of 1998's mutual fund investors in these words:
"How could the market be up 22% in 1998 and my returns be only half that?"
"Why, you ask, do all my mutual funds suck?"
While we Fools hesitate to endorse the crude language employed by
SmartMoney, we cannot help but be enthused that such a publication is
asking the right question. And so succinctly.
SmartMoney, we cannot help but be enthused that such a publication is
asking the right question. And so succinctly.
But it wasn't just in 1998 that investors should have been directing
such epithets toward their mutual funds. For many years now the record
for equity mutual funds has not been good. Though countless millions
of dollars of shareholders' money is spent annually by mutual funds
promoting themselves and the notion that they have "expert" stock
pickers, the sad truth (or the funny truth, if you're in a laughing
mood) is that the vast majority of mutual funds underperform the
returns of the stock market (as represented by the S&P 500 index).
Because of their excessive annual fees and poor execution,
approximately 80% of mutual funds underperform the stock market's
returns in a typical year. Over the past couple of years, that number
has been going up, as mutual funds have been raising their fees to
even higher levels.
such epithets toward their mutual funds. For many years now the record
for equity mutual funds has not been good. Though countless millions
of dollars of shareholders' money is spent annually by mutual funds
promoting themselves and the notion that they have "expert" stock
pickers, the sad truth (or the funny truth, if you're in a laughing
mood) is that the vast majority of mutual funds underperform the
returns of the stock market (as represented by the S&P 500 index).
Because of their excessive annual fees and poor execution,
approximately 80% of mutual funds underperform the stock market's
returns in a typical year. Over the past couple of years, that number
has been going up, as mutual funds have been raising their fees to
even higher levels.
The average actively managed stock mutual fund returns approximately
2% less per year to its shareholders than the stock market returns in
general. There is currently no reason to believe that this
differential will improve, or that actively managed mutual funds as a
group can ever outperform the stock market's average returns. For that
reason, investors who are going to invest in mutual funds rather than
in individual stocks should hold a very, very, very strong bias toward
investing in index funds, which invest across the board in a stock
market index.
2% less per year to its shareholders than the stock market returns in
general. There is currently no reason to believe that this
differential will improve, or that actively managed mutual funds as a
group can ever outperform the stock market's average returns. For that
reason, investors who are going to invest in mutual funds rather than
in individual stocks should hold a very, very, very strong bias toward
investing in index funds, which invest across the board in a stock
market index.
The costs of being in the average actively managed mutual fund over
time are, put simply, very, very severe. Although 2% may not sound
like that much of a differential when the market is returning roughly
20% per year as it has from 1995 through 1998, the standard returns
for the stock market historically are closer to 10%. Consider whether
this is severe enough for you: over 50 years, a $10,000 investment
will compound to $1,170,000 at 10% returns per year, but to only
$470,000 at 8% per year.
time are, put simply, very, very severe. Although 2% may not sound
like that much of a differential when the market is returning roughly
20% per year as it has from 1995 through 1998, the standard returns
for the stock market historically are closer to 10%. Consider whether
this is severe enough for you: over 50 years, a $10,000 investment
will compound to $1,170,000 at 10% returns per year, but to only
$470,000 at 8% per year.
Vanguard founder John Bogle looks at these numbers and says: "[O]ur
hypothetical fund investor has earned $1,170,000, donated $700,000 to
the mutual fund industry, and kept the remainder of $470,000. The
financial system has consumed 60% of the return, the fund investor has
achieved but 40% of his earnings potential. Yet it was the investor
who provided 100% of the initial capital; the industry provided none.
Confronted by the issue in this way, would an intelligent investor
consider this split to represent a fair shake? Merely to ask the
question is to answer it: 'No.'"
hypothetical fund investor has earned $1,170,000, donated $700,000 to
the mutual fund industry, and kept the remainder of $470,000. The
financial system has consumed 60% of the return, the fund investor has
achieved but 40% of his earnings potential. Yet it was the investor
who provided 100% of the initial capital; the industry provided none.
Confronted by the issue in this way, would an intelligent investor
consider this split to represent a fair shake? Merely to ask the
question is to answer it: 'No.'"
What explains this differential in performance between the stock
market and the mutual funds that invest in the stock market? You would
think that all these sartorially splendid MBA-grad mutual fund
managers who are selected daily by the Wise financial media to tell us
how we should invest our money could pick some reasonable stocks every
once in a while. That's their job after all, right? Nobody would want
to fail in their job as much as mutual fund managers apparently do, so
what's going on here? Is it because managers of mutual funds are
actually bad stock-pickers? And, by the way, who's this John Bogle,
and what's really so great about an index fund?
market and the mutual funds that invest in the stock market? You would
think that all these sartorially splendid MBA-grad mutual fund
managers who are selected daily by the Wise financial media to tell us
how we should invest our money could pick some reasonable stocks every
once in a while. That's their job after all, right? Nobody would want
to fail in their job as much as mutual fund managers apparently do, so
what's going on here? Is it because managers of mutual funds are
actually bad stock-pickers? And, by the way, who's this John Bogle,
and what's really so great about an index fund?
