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Do You Know This Dirty Little Secret About Mutual Funds?

Don't get suckered by Wall Street's 'conventional wisdom'


“People should only buy mutual funds with experienced portfolio managers that have good long-term track records.”

“Investing in highly rated mutual funds with at least 4 or 5 stars is a sure-fire way to choose the best fund.”

“Our firm screens thousands of mutual funds to help our clients find funds and managers that have stood the test of time.”

The above thinking is just a small sample of the entrenched conventional wisdom the investing public is constantly sold … and it’s dead wrong.

In fact, new research totally upends the fairyland theory that mutual funds with a long-term performance track record are better than funds with no track record.

AUDIO: Ron DeLegge Grades a Professional Poker’s Investment Portfolio + Chad Karnes, CMT interview on the New World Disorder

A research report titled “Scale and Skill in Active Management” (Pastor, Stambaugh, and Taylor) published at the National Bureau of Economic Research in February examined more than 3,000 mutual funds from 1979 to 2011. Researchers discovered that funds with three years or less in age actually outperformed funds with more than 10 years of history by almost 1% annually.

These numbers, while shocking to some, follow a consistent pattern I’ve seen in my evaluation of mutual fund  investment portfolios with my Portfolio Report Card. There are only two types of mutual fund owners: Those who know everything and those who know nothing. Guess which group is larger?

The findings can also be interpreted as damning proof that backward-looking measurement tools used by large mutual fund rating firms are completely useless to forward-looking investors. “Purely statistical, backward looking calculations provide no help in identifying superior managers,” said David F. Swensen in his book, Unconventional Success: A Fundamental Approach to Personal Investment.

The mutual fund report, which used data from Morningstar and the Center for Research in Security Prices to uncover its findings, observed:

“We find strong evidence of decreasing returns at the industry level: As the size of the active mutual fund industry increases, a fund’s ability to outperform passive benchmarks declines. At the fund level, all methods considered indicate decreasing returns. Finally, we find that performance deteriorates over a typical fund’s lifetime. This result can also be explained by industry-level decreasing returns to scale.”

This research confirms that while historical fund performance (good or bad) tells you a lot about the past, it doesn’t tell you much about the future. This is even true when evaluating the performance potential for new mutual funds that lack a performance history!

Here’s another reason why tenured mutual funds as a group underperform: Funds that are 10 years in age or older are likely to have more assets invested in them compared to newer funds. That can lead to asset bloat: where a fund’s size is so large, it becomes unmanageable. In turn, that causes the actively managed funds (such as American’s Growth Fund (AGTHX)) to behave just like a low-cost index fund — even though it’s still charging investors much higher fees!

While there may be some psychological comfort in knowing you own a large multibillion fund that behaves like a stock  (such as the Vanguard 500 Index Fund (VOO)) or bond index (iShares Aggregate Bond Fund (AGG)) and lots of other people do too, it’s one of the biggest rip-offs the fund industry doesn’t want you to know about.

Roughly one-third of U.S. mutual fund assets — several trillion dollars — are parked in “closet index funds,” according to research from Antti Petajisto, a former Yale University professor.

Do you own closet index funds? What about mutual funds that consistently underperform? How is it impacting the performance of your total portfolio?

Ron DeLegge’s Portfolio Report Card examines all the important factors of your portfolio’s construction including taxes, fees, and risk. Ron uses a grading scale of A and B for passing, C for more work, and D through F as flunking scores. Is your portfolio smart enough to score an A? If it is, Ron pays you $100.

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