Mutual fund investing presents one of the great conundrums of personal finance. It seems logical that a professional manager, armed with piles of data and research analysts to decipher it, should be able to weed bad investments from good and produce returns that are better than the collective market return.
While many mutual fund managers occasionally post periods of exceptional returns, research is unveiling that performance outliers are more likely because of luck than any repeatable skill. Persistent mutual fund outperformance of a comparative index is the Sasquatch of investing. It doesn’t exist.
That doesn’t mean it’s impossible for a professional money manager to add value. But it’s difficult to post market-beating returns every year or quarter. This is particularly true for U.S. stock mutual funds and to a lesser extent for international stock funds and bond funds. Many fund managers have produced noteworthy long-term records where the totality of performance has been better than the market, but from time-to-time, their investment approach is out of favor and lags the passive index (e.g., the S&P 500).
A good example of this is Oakmark International Fund (OAKIX). Over periods longer than three years, the fund is among the top 5 percent of its peers. Over 15 years, it has nearly doubled the return of its benchmark. But over the past year, its peer-relative performance has reversed. It has been among the bottom 5 percent of its category. Morningstar’s fund analysts give Oakmark International five stars and a gold rating, but the conundrum is clear. U.S. stock mutual funds offer many more examples of intermittent outperformance interrupted by lagging periods.
INVESTORS UNDERPERFORM FUNDS, FUNDS UNDERPERFORM THE MARKET
It would seem that evidence of solid longer-term returns would be enough to create patience from investors. But few investors have the staying power required to experience the long-term outperformance amid short-term fluctuations. Investors pour money into funds when they are hot and redeem when they are not, therefore, few investors actually receive the same stated performance as the funds they invest in.
Research from Morningstar as of the end of 2013 demonstrated that over the preceding 10 years the average mutual fund investor underperformed the average mutual fund by 2.49 percent per year. The typical investor earned 4.8 percent annualized compared with 7.3 percent for the typical actively managed mutual fund across all asset categories.
Even if an investor received the returns of the average mutual fund, they may still trail the return available from simply holding a passive, market-tracking index fund with very low costs. The latest measures from S&P Dow Jones Indices show that over the three years through June 30, 85.9 percent of all U.S. stock fund managers failed to outperform passive benchmarks. Over five years, 73.6 percent lagged. International stock managers and bond managers beat their benchmarks more often but over many periods it is still not a majority that do.
Perhaps you’re thinking that even though the majority of the industry trails its benchmark that you can still identify those mutual fund managers that have and may continue to outperform. The challenge is that it’s not always the same mutual funds that outperform or underperform. Funds move across borders regularly as their investment approach moves in and out of favor with market conditions.
WHAT YOU CAN DO
• Reduce your emphasis on market-beating performance and increase your understanding of the returns needed to make your financial plan work, taking no more risk than necessary to reach your goals.
• The level of risk in your investment portfolio is mostly attributed to the weight of stocks vs. bonds, more so than the selection of any particular individual investment. You can control the amount of risk you take by managing your mix of stocks vs. bonds, U.S. vs. international, etc. This is more critical than trying to pick just the right funds.
• Don’t base investment decisions solely on performance. When evaluating mutual funds, try to understand the people and process involved and what attributes have created short and long-term outcomes. Especially learn if the same manager who generated the performance still leads the fund.
• Use actively managed mutual funds for the portions of your portfolio where they are more likely to generate better returns than passive funds. These tend to be emerging markets stocks, global bonds, and alternative investments.
• You can reduce the costs of your investments thereby increasing the amount of return you get to keep by using more low-cost mutual funds and exchange-traded funds.
• If your employer retirement plan offers only actively managed mutual funds – especially if they are high-cost funds – request that index funds be added to the plan.
• Invest in funds where the manager has committed a meaningful amount of their own money to the strategy. It’s comforting to know that the person making the buy and sell decisions has their money right next to yours.
Gary Brooks is a Certified Financial Planner and the president of Brooks, Hughes & Jones in Old Town Tacoma. An extended version of this article is available via blog post at bhjadvisors.com.