The great mutual-fund trap, according to authors Gregory Baer and Gary Gensler, is baited by the desire for "beating the market." Investors end up paying extra fees and enduring undue risks in hopes of attaining this elusive goal. Even if investors know that most funds underperform the market over time (and the authors provide ample evidence attesting to funds' underperformance), investors tend to think they can identify those few funds that will beat the market (see "Inside the The Great Mutual Fund Trap" for a review of their book).
Doing so isn't easy, Baer and Gensler argue, since funds that performed well in the past tend to regress back to the mean in years following. Look no further than the average tech fund's five-year peak-to-trough performance record for evidence of this trend.
In this edited excerpt of Chapter 1 from The Great Mutual Fund Trap, the authors show how poorly most actively managed mutual funds perform and urge investors to be satisfied with mere "market performance" and invest passively through an index fund.
Chapter 1: Money Management in a Nutshell
Every day there is a parade of money managers interviewed on CNBC or featured in Money or similar magazines. Every time we see them, we can't help but think of flipping coins.
Imagine that, instead of picking stocks, these scores of men and women each flipped one hundred coins per day, with the goal of producing the maximum number of "heads" possible. Viewers tune in to see who's doing well and bet on their favorite flippers.
Over time, the flippers' task is essentially hopeless: statistics doom them to an average performance of 50% heads. If you observe them on only one day, though, there will be winners and losers. While most will have around 50 heads, some will have 57 or 43.
Now suppose that some of the coin flippers are permitted to raise the stakes of each given flip by taping up to five coins together. For example, if one tapes four coins together, each flip will yield either four heads or four tails. Now, we might expect some of our flippers to produce 60 or 64 (or 40 or 36) heads in one day. By taping the coins, they are taking on risk (the possibility of four tails at once) in return for the possibility of reward (four heads).
Imagine, then, the Coin Flipping News Network (CFNN), giving us 24-hour-a-day coverage of the flipping market. In comes coin flipper Lee with 56 heads, touting her latest tactic -- say, many revolutions of the coin, with three taped together. Long forgotten is last week's guest, who had favored the few-revolution, one-coin-at-a-time tactic that worked so well during the last 500 flips but is now seriously out of favor. "Momentum" viewers favor those who have recently had more heads, while "value" viewers favor those who have recently had more tails.
Above all, viewers are assured that they are not capable of flipping the coins themselves -- that they must rely on the experts to do it for them. And they are convinced that they should never be satisfied with just 50% heads -- that is, "market" performance.
The current state of money management is similar to this example -- only worse. The returns for money managers are like those of our coin flippers. Most tend to stay close to the mean, while riskier funds tend to produce more volatile returns that balance out over time. The difference, though, is that whereas coin flipping is free, money management is not.
For that reason, the chances of your money manager beating the market are small. Evidence suggests that the average actively managed mutual fund underperforms the market three years out of five. According to data at Morningstar (which maintains a comprehensive database on fund performance):
• Through the end of 2001, there were 1,226 actively managed stock funds with a five-year record. Their average annualized performance trailed the S&P 500 Index (a measure of the U.S. stock market) by 1.9 percentage points per year (8.8% for the funds and 10.7% for the index). There were 623 actively managed stock funds with a 10-year record. Their average annualized performance trailed the S&P 500 by 1.7 percentage points per year (11.2% for the funds and 12.9% for the index).
• These figures include the sales loads charged by many funds. Loads are akin to brokerage commissions and come straight out of your returns. They are charged by many funds when you either buy or sell shares of the fund. Even with those loads excluded, however, the average five-year return trailed the S&P 500 by 1.4 percentage points per year and the average 10-year return trailed by 1.4 percentage points per year as well.
Looking over a longer period of time yields a similar result. Excluding sales loads, the 406 actively managed stock funds that had been around for 15 years or more trailed the S&P 500 Index by 1.5 percentage points per year.
• None of these aggregate numbers includes failed mutual funds, which would tend to have poorer performance and bring the averages down significantly. The exclusion of these mutual funds is called survivorship bias. The most comprehensive study of survivorship bias concluded that it inflates industry returns by 1.4% over a 10-year period and 2.2% over a 15-year period. With returns corrected for survivorship bias, the average actively managed funds trail the market by about 3 percentage points per year.
How can such a clever, hardworking group of fund managers trail the market by 3 percentage points per year? It's actually rather simple. The collective performance of stocks held by actively managed mutual funds, prior to any direct or indirect costs, generally will equal the performance of the market as a whole. With around $3 trillion in stock holdings, these funds basically represent the market.
But then along come management fees, trading costs, and sales loads. All of these costs weigh heavily on actively managed funds. The failure of almost all money managers to earn back their costs does not make them crooked or stupid. The problem is that their direct and indirect costs severely handicap their performance.
Nonetheless, each year some money managers will outperform the average fund, and even the market as a whole. The question is, can you identify these managers in advance of their market-beating performance? There is no reason to think so. As an individual investor, you have no comparative advantage in choosing those managers. In other words, there is no reason to believe that you will do any better a job picking stock pickers than you would picking stocks. If you can't do the latter, why would you expect to do the former?
Most investors simply choose funds based on past performance, but past performance truly is no guarantee of future results. The fact that a fund has outperformed the market for the past year, 5 years, or even 10 years turns out to be a very poor predictor of whether it will outperform the market in the future. Funds that are above average for a time tend to regress to the below-market performance of the average fund.
Let's go back to our coin-flipping example. There were about 1,100 stock funds in 1991, and we know that each year about two out of five such funds (40%) have outperformed the market. If the identity of those 40% is just like coin flipping -- that is, produced by random chance -- how many funds would we expect to outperform the market each and every year over the next 10 years? (In other words, how many beat the market in 1991, 1992, 1993, all the way to 2000?) Simple statistics tell us that by random chance between 0 and 1 fund should outperform the market each and every year.
That probably seems an improbably low number to you. But what has happened in reality? Over the 10 years 1991-2000, only one fund (Legg Mason Value Trust) outperformed the S&P 500 every year. While we are happy for Legg Mason and its manager, Bill Miller, we view that outcome as roughly in line with random chance and as an indictment of active fund management. To the financial media, that outcome is a vindication of active fund management, and profiles of Bill Miller are everywhere. We'll let you decide.
How You Can Do Better
"Okay," you say, "so what do I do instead?"
Here, in a nutshell, is how we see it. Everyone investing in the stock market now has a wonderful option. Claim the same returns as the broad market at remarkably low cost, with the ability to defer almost all capital-gains taxes. This option exists through traditional open-end index funds and their younger cousins, exchange-traded index funds. It takes minimal effort. It also leaves you free to work more or play more, or a little of both.
We believe that the best analogy to index investing is the generic drug market. Brand-name drugs and their generic equivalents provide the same medicinal benefits. The brand-name drugs cost far more, however, because their owners must recoup the costs of research and development. The generic drug makers incur none of those development costs and instead free ride on the expertise of the "active" drug companies. Informed consumers buy generics. Consumers, however, must wait a few years for a generic drug, as the patent laws were designed to allow inventors (the active drug companies) a period of time without competition to help recoup their research costs by charging consumers high prices.
Index funds are the generics of investing. Because they needn't hire the highly paid stock pickers required for active investing, or pay the transaction costs their strategies impose, they are a bargain for investors. Moreover, "generic" mutual funds, or index funds, are available from the beginning of each market "invention." They adjust daily, even hourly, to track the market prices being established by active money managers. Thus, for stock investors, the free riding can start today.
The mutual fund and brokerage industries belittle indexing because it is deadly competition for their higher-margin products. The financial media ignore it because it makes such lousy copy. Have you ever read anything more boring than a profile of an index-fund manager? Can you imagine a cover story entitled "Ten Hot Index Funds to Buy Now!"?
We consider the indexing option a miracle. We consider it a testament to technological innovation, human imagination, and market capitalism. If you had told a Wall Street executive 50 years ago that individual investors would be able to purchase shares in 500 of the largest U.S. companies at zero commission and with annual management fees of 18 cents per $100 invested, he would have fainted dead away. You should be equally impressed.
Attractive alternatives to expensive money management do not end with equity investing. Investors now have new ways to buy bonds more cheaply than ever before. Investors have online access to sophisticated asset allocation and risk management tools that were unavailable even a few years ago. And investors willing to do their homework can now legally shield more of their investments from taxation than ever before.
What it really takes to improve your returns and diminish your risks is a willingness to stop focusing exclusively on the movement of the markets. The more you focus on the structure of your investments -- their costs, diversification, and tax status -- the better you will do. If you end up sharing this view -- a conclusion quite contrary to what money managers and the financial media tell you every day -- you will begin investing very differently.
Excerpted from The Great Mutual Fund Trap by Gregory Baer and Gary Gensler, copyright 2002 by Gregory Baer and Gary Gensler. Reprinted by permission of Broadway Books, an imprint of the Doubleday Broadway division of Random House, Inc.