We have all heard the mutual fund’s industry sales pitch: invest your retirement savings in a mix of mutual funds, reinvest the returns, leave it there and trust in the judgment of the professional money manager, and then retire a multi-millionaire. Nice story, but for many people the reality is often disappointing.
There are two things every investor should know about mutual funds. The first is that fund managers collect fees, often based on assets under management rather than on investment performance. In other words the fund collects their fees in years when the fund is up, the fund is flat, and even when the fund is down. Those fees can devastate long-term returns.
Defenders of mutual funds argue that the professional money managers are worth it because they have the pulse on the markets and avoid the crashes that affect the rest of us and are ahead of the curve on the next big market moves. In reality most mutual fund managers can’t even match the performance of a benchmark like the S&P 500. Two-thirds of actively managed stock funds have failed to beat the S&P 500 over the last three years. This is similar to 10, 15, and 20 year performance. Actually out of the more than 7,000 mutual funds one can purchase only eight have beaten the S&P 500 every year for the past decade. The reality is that most mutual fund managers don’t miss the crashes and most are late to recognize new opportunities. Most passive investors would actually make greater returns by investing in an S&P 500 index fund and mimic the benchmark.
Part of the reason for that dismal performance is that funds have billions of dollars under management and thousands of investors. This makes it very difficult for a fund to makes sudden moves and react quickly to change. One of the biggest reasons the mutual industry fails to perform are the fees. Annual fees of one to two percent set a high hurdle to beat every year before the fund does the first thing with the money.
The biggest mistake that mutual fund investors make is that they give someone else the responsibility of managing their money and then they don’t look to see how their investments are performing to see if their fund is continuing to perform well compared to the market. Then when they do make moves it is usually based on emotion (fear or greed): buying into funds when the market is up and selling when it is headed down. According to one study the S&P 500 returned 9.14% a year over a 20-year period ended in 2010, however the average investor only earned 3.83% a year. The typical mutual fund investor actually earned an actual annual return of 1.6% below their funds’ stated performance due to impulse buying and selling. If you let yourself be guided by your emotions, your investments will do poorly no matter what fund you invest in.
Mutual funds need to be actively monitored just like individual stocks to see if they are over valued or undervalued and regularly graded to see how they are performing versus the market and other mutual funds. Passive investors who don’t want to spend time following markets or picking winners (whether individual stocks or individual funds), the better, safer, options that will build wealth over time may be index funds.