The Gruesome Truth About Actively Managed Mutual Funds

by Daniel Putnam | October 25, 2013 1:48 pm

An old saw about baseball is that it’s the only job where you can fail 70% of the time and still be considered a success.

penny stocks, young investors[1]Clearly, this phrase was coined before the advent of actively managed mutual funds. In the past five years, fund managers have exhibited an extraordinary level of futility that would make a 30% success rate a major improvement.

How bad has it been? Standard & Poor’s compiles mutual fund performance data for 35 categories encompassing domestic equity, international equity and bond portfolios into its semiannual SPIVA scorecard. In the five years through June 30, actively managed funds have outperformed their benchmarks in only three categories: International Small-Cap, Global Income and Investment-Grade Intermediate bonds.

Only within International Small-Cap was the positive performance gap substantial, with about 82% of actively managed funds beating their benchmarks. In Global Income and Investment-Grade Intermediate, only 51% and 60% of managers, respectively, came out ahead.

That’s it. Outside of these three groups, the performance results were beyond abysmal. Across all 35 categories, a full 73% of funds lagged their benchmarks, including 79% of domestic equity funds. The three worst categories were all bond funds: High Yield (93% underperformance), Long Government (96%) and Investment-Grade Long (90%).

Notably, even in less-efficient market segments where the fund companies’ marketing teams tout their managers’ ability to generate outperformance through research — Small-Cap, Emerging Markets and High Yield, to name three — the vast majority of funds lagged their benchmarks. The full SPIVA report is available here[2].

The conclusion is inescapable: Active managers, as a group, simply don’t add value. Is it any wonder that assets in exchange-traded funds are growing so quickly, and that advisors are increasingly putting their clients in ETFs rather than funds?

Despite these trends, the majority of investors still aren’t getting the message: according to the Investment Company Institute (ICI), only 17.4%[3] of domestic equity fund assets are invested in index funds. Unfortunately, everybody else is leaving returns on the table. And with nearly half of mutual funds investors under the age of 54, there’s plenty of time for this annual shortfall to compound.

The reason for the underperformance is fairly straightforward, but it bears repeating nonetheless. When funds’ management fees are taken off the top, the manager automatically starts from behind. ICI reports[4] that the average actively managed equity fund charges an annual fee of 0.92%, while actively managed bond funds average 0.65%.

In order to make up this gap and deliver an added performance advantage within a given year, the manager has to outperform by picking the best securities from what is often a fairly limited universe — say, the Russell 1000 Index. With so many managers trying to accomplish the same objective, the odds of outperforming in a given year are long, and the odds of outperforming consistently over time are nearly impossible.

In short, there is truly no reason for a self-directed investor to own actively managed funds over index funds. Just as someone who stays at the roulette wheel long enough will feel the pain of the green house numbers, so too will investors in active funds find themselves in the hole over time.

I’ll close this article with an anecdote. Earlier this year, I was interviewing a manager of a domestic equity fund who had underperformed across all time periods. I asked him, “If a potential client asked you why he or she would buy this fund, what would you say given its track record?”

He paused for a moment, and replied, “Honestly? There’s no logical reason why someone should buy this fund.”

I couldn’t have said it better myself.

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