Few investors understand the stunning odds that are likely dooming their returns. The system is rigged against investors and in favor of those who “manage” their money. Active mutual fund families, brokers and insurance companies are the big winners in this process. Investors barely scrape by.
Here’s some historical data for your consideration. It may fundamentally change the way you invest.
Overview of the mutual fund industry
Most of you probably invest in mutual funds. Since 2000, assets under management in these funds have grown more than 213 percent. The number of funds available in the marketplace has increased by 46 percent. By the end of 2014, there were more than 5,200 U.S.-based mutual funds, collectively managing about $10 trillion in shareholder wealth.
With such a broad array of choices, selecting the mutual funds that are optimal for your portfolio can be a daunting experience. Many of you rely on brokers and insurance companies for guidance. Part of their standard sales pitch is that they have the ability to recommend mutual funds likely to “beat the market” by outperforming a standard benchmark (like the S&P 500 index).
The odds of surviving
Despite the SEC-mandated warning that “past performance is not necessarily indicative of future results,” brokers frequently tout past performance and imply that it’s likely to continue into the future. It’s easy to identify managers with stellar track records. Unfortunately, past outperformance often does not persist.
For fund-picking brokers, the initial hurdle is not identifying outperforming actively managed mutual funds. It’s a far lower bar. Selecting funds that will simply survive over a long period of time is far more difficult than you might imagine.
Most mutual fund investors plan to hold their funds for at least 15 years, which makes long-term data meaningful. For the 15-year period ended Dec. 31, 2014, only 42 percent of stock funds in existence at the beginning of that timeframe managed to survive until the end of it. The survival rate of fixed income funds was about the same.
The next time your broker recommends a stock or bond mutual fund, ask this question: “How likely is it that this fund will survive for 15 years?” Run for the door if the response is anything other than, “It’s more than likely the fund I’m recommending will not survive that entire period.”
The odds against outperformance
Let’s assume you were one of the few lucky investors. You beat the odds and the mutual fund you, or your broker, selected at the beginning of the 15-year period managed to survive. How likely is it that your stock or bond fund outperformed its benchmark over that entire 15-year period?
This is a significant issue. If your fund did not outperform, you would have been better off in a low management fee index fund.
For the 15-year period ended Dec. 31, 2014, only 19 percent of stock mutual funds and 8 percent of bond funds survived and outperformed their benchmark. Those are depressing odds.
Winners don’t persist
It would be easy to pick a winning mutual fund if you could rely on past performance. Unfortunately, as the evidence indicates, you can’t. Mutual fund families, however, spend vast quantities of marketing dollars extolling the track record of funds that beat their benchmark. Don’t be fooled.
For the period from 2000 through 2009, 25 percent of stock funds that survived managed to beat their benchmark. There were a total of 682 “winning” funds in this category. Perhaps your broker made a compelling case that the long track record of outperformance achieved by these funds was an excellent reason for buying them. If you fell for this pitch, you likely would have been disappointed. For the subsequent period, from 2010 to 2014, only 28 percent of those funds repeated their outperformance.
The data was better for bond funds. While only 7 percent of bond funds both survived and outperformed during the period from 2000 through 2009, 52 percent of the outperformers beat their benchmark for the subsequent period from 2010 to 2014.
If you are looking for one factor likely to determine whether a fund will outperform, focus on its costs. Because costs reduce your net return, a fund has to add sufficient value to exceed its costs. Costs can include not just expense ratios, but also trading costs and bid-ask spreads.
Over the 15-year period ended Dec. 31, 2014, 29 percent of lower-cost stock funds outperformed, compared to only 9 percent of more expensive stock funds. Only 11 percent of the lower-cost fixed income funds outperformed. That’s compared with 2 percent of the more expensive funds.
Here’s the bottom line: costs matter. You may be able to reduce the odds of picking a persistent loser by avoiding expensive, actively managed funds.
The harsh reality is that the vast majority of actively managed funds are unable to outperform their benchmarks. Funds that do are often unable to repeat their outperformance over extended periods of time.
The odds are stacked against you if your investing strategy is premised on your ability to find a “winning” mutual fund. The hurdle of high fees, high turnover and other costs will make your chances of finding this needle in a haystack daunting and unreliable.
Instead of engaging in this often fruitless exercise, and enriching your broker and mutual fund family in the process, consider purchasing only low management fee index funds as part of a globally diversified portfolio arranged in a suitable asset allocation. By doing so, you’ll increase the odds of achieving your retirement goals.
It’s time to switch the odds in your favor.
This commentary originally appeared May 12 on HuffingtonPost.com
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