Almost all mutual funds in the world fail to do their job. You’ll find better odds at the racing track than you will buying mutual funds. So why do people still buy them?
Almost everyone in the developed world has a stake in a mutual fund. Even if you didn’t actively buy into any mutual fund, your pension fund is most likely invested in some of these vehicles. Mutual funds seem like a logical solution they have been hailed by governments, universities and banks as the perfect solution for individuals to participate in the equity markets.
The original idea behind mutual funds was very valid. In 1960.
The problem was that it took substantial money and work to obtain a general exposure to the equity markets. Without an index fund, it was difficult to buy a basket of stocks and invest in the overall market. Mutual funds solved that problem.
The mission of a mutual fund is not to make money per se. At least not for the investor. The fund is supposed to track a particular market index and attempt to surpass it. Each mutual fund has a very exactly defined benchmark index. It could be something as simple as the S&P 500 or something a little different like MSCI World All Share ex Japan, STOXX 600 Food and Beverage Sector Index.
A mutual fund’s job is to track its assigned index very closely. In reality this means buying almost exactly the same shares. The fund is given a tracking error budget, meaning that it’s not allowed to deviate from index more than the this TE budget.
The fund has costs to pay of course. There are fixed fees such as management fees and less visible ones like commissions. The total fees for a mutual fund is reported as the Total Expense Ratio (TER). It’s not cheap to run a mutual fund.
So how do you beat the index if you have to buy almost the exact same shares and still have plenty of costs to pay?
Almost no mutual fund manages to even match the benchmark return over any longer period. It’s always easy to throw generic statements like that around on the internet, so let’s see if we can’t find some data to back this up.
The S&P Indices versus Active Funds Scorecard report, aka SPIVA, tracks the performance of American mutual funds. The table below shows their report for 2013. It looks pretty much the same every year.
|Fund Category||Comparison Index||One Year (%)||Three Years (%)||Five Years (%)|
|All Domestic Equity Funds||S&P Composite 1500||46.05||77.53||60.93|
|All Large-Cap Funds||S&P 500||55.80||79.95||72.72|
|All Mid-Cap Funds||S&P MidCap 400||38.97||74.00||77.71|
|All Small-Cap Funds||S&P SmallCap 600||68.09||87.32||66.77|
|All Multi-Cap Funds||S&P Composite 1500||52.84||80.38||71.74|
|Large-Cap Growth Funds||S&P 500 Growth||42.63||79.78||66.67|
|Large-Cap Core Funds||S&P 500||57.74||80.56||79.39|
|Large-Cap Value Funds||S&P 500 Value||66.56||76.75||70.26|
|Mid-Cap Growth Funds||S&P MidCap 400 Growth||36.72||79.37||86.19|
|Mid-Cap Core Funds||S&P MidCap 400||43.48||67.27||83.94|
|Mid-Cap Value Funds||S&P MidCap 400 Value||45.33||73.97||67.14|
|Small-Cap Growth Funds||S&P SmallCap 600 Growth||55.61||86.10||69.60|
|Small-Cap Core Funds||S&P SmallCap 600||77.70||91.10||74.73|
|Small-Cap Value Funds||S&P SmallCap 600 Value||78.99||88.00||60.74|
|Multi-Cap Growth Funds||S&P Composite 1500 Growth||38.14||86.54||68.56|
|Multi-Cap Core Funds||S&P Composite 1500||62.74||84.51||77.15|
|Multi-Cap Value Funds||S&P Composite 1500 Value||49.21||70.68||67.98|
|Real Estate Funds||S&P U.S. Real Estate Investment Trust||50.00||86.71||80.28|
Those percentages? They don’t show how many funds managed to do their job. They show the percentage of failure. Over a few years time, 75-90% of all mutual funds fail to do what they are supposed to do. They fail to beat their benchmark.
If almost all mutual funds fail to perform and if it can be proven so easily, why do people still invest in them? Why are there billions of dollars in mutual funds? Why to whales beach themselves?
If you want to have general equity exposure, mutual funds is the worst way to go. There’s a wide scale and many possible alternative. Most people are simply unaware of these alternatives. After all, the adviser at the bank told you that it’s prudent to invest in mutual funds. As long as it’s their own bank’s mutual funds of course.
In the next series of articles on this site, I’ll explain some alternatives to mutual funds. Some are better than others. They may not be what you think.
If you are suspicious of my sudden switch to articles about the stock market, you are absolutely right. I have a new book coming out soon. This time the topic is systematic equity momentum. Like with my first book, I will explain all the details and all the rules. There will be no trading systems for sale or other nonsense. It’s all in the book.
Of course, I won’t tell you the details now. Then you wouldn’t buy the book.