The real trouble with mutual funds.

How to understand Wall Street.
Dec. 1 2004 6:36 AM

Money for Nothing

The real trouble with mutual funds.

Read Henry Blodget's detailed disclosure statement here. To read previous installments in the Complete Guide to Wall Street Self-Defense, click here.

Used properly, mutual funds are powerful tools. They allow investors with little money and time to pool resources and benefit from the same services, information, clout, expertise, and economies of scale as large institutions. They also provide immediate diversification, without the hassle and cost of acquiring and managing a portfolio of individual securities.

Alas, these benefits come at a price: First, mutual funds often aren't used properly. Second, and more troublingly, the vast majority of funds get paid an aggregate of tens of billions of dollars a year for accomplishing nothing (or worse than nothing).

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On the first issue, mutual funds should be used as deliberate elements of a broader investment plan. Unfortunately, many people imagine that fund managers play the same role in the investment process as financial advisers: They invest your money in a way that makes sense for you. Most fund managers don't do anything of the sort, of course, and not because they are shifty or incompetent. Most fund managers do what they are hired to do: trade stocks or bonds according to the tightly proscribed criteria of a given fund. But these criteria may have little or no relevance to you.

As described here, the most important part of money management is asset allocation (how much of your portfolio you place in stocks, bonds, real estate, etc.). Asset allocation is so critical that, according to some studies, it accounts for more than 90 percent of the variability of returns. Appropriate allocation depends to a large extent on your goals, time horizon, and risk tolerance, and fund managers do not make personalized allocation decisions. Instead, they simply offer a vehicle with which to implement them.

If a fund buyer understands how to make allocation decisions, then (some) mutual funds are logical tools to use in a portfolio. Alas, in this age of do-it-yourself finance, many people skip right over the tedious allocation process and head straight for the sexy stuff: fund picking. And, in so doing, they set the table for disaster.

If you put all your eggs in a super-hot technology-fund basket, for example, it doesn't matter whether your fund is the best or worst of the lot: If tech tanks, you're headed for the poorhouse. Similarly, if you bet your daughter's college money on that top-quartile U.S. equity fund, you must hope that the U.S. equity market doesn't stagnate for a decade (because if it does, it's second-mortgage time). Bottom line, the appropriate use of mutual funds requires significant portfolio management expertise, and statistics on fund turnover and money flows suggest that many buyers just don't have it.

But the bigger issue is that active money management—aka stock-picking, the strategy employed by most funds—doesn't usually work. According to study after study, the vast majority of fund managers can't generate enough extra performance from active trading to offset the costs of their efforts (costs that include salaries, bonuses, and fund company profits). This problematic finding doesn't stop fund companies from selling active-management prowess, of course—or from collecting huge active-management fees even when performance stinks. Your odds of picking a market-beating fund are somewhere between one in six and one in 30 (roulette-like); the fund industry's chance of collecting big fees, meanwhile, is 100 percent.

If alternatives didn't exist, active managers could just hide behind the rhetoric about offering small investors a simple way to pool resources and diversify, etc. Alas, alternatives do exist. Passive funds buy all the stocks that meet given criteria and leave stock-picking to folks who hope that they can defy the odds (and to their customers). Because passive management costs less than active management—fewer expensive MBAs, lower trading costs, lower research costs, lower taxes—passive funds generally do better than active funds: What they lose in performance (surprisingly little), they more than make up in costs.

Academics have been wrong before, of course, and perhaps some hidden advantage of active management has been overlooked. (Personally, I hope so; active management is a dream job, and if I hadn't been afforded time to read the studies—by getting tossed out the industry—I'd probably be doing it right now.) If the academics are wrong, however, the fund industry has been awfully quiet about it. Usually, when the value of an entire industry's primary product is questioned, the industry responds to the charge: "The methodology was flawed. … " "The studies failed to account for …" To my knowledge, the fund industry has yet to respond persuasively to this charge. Until it does, we might tentatively conclude that, intentionally or not, most fund customers are being taken to the cleaners. (One obvious remedy would be for fund companies to refund fees when active funds fail to beat their passive benchmarks; fund companies probably know a bad bet when they see one, however.)

Should you care about the near-futility of active management? If your time horizon is only a few years, no. Over this period, the cost drag won't amount to much, and you might as well play a few spins of the active-management roulette wheel (some funds do beat the market, and hope springs eternal). If you're investing for the long term, however, you should care a lot. On average, active funds underperform passive funds by about a percentage point a year (or more). Over 20 years, assuming 10 percent annual appreciation, this difference will eat nearly a fifth of your return. Over 40 years, it will gobble almost a third.

Henry Blodget is the founder, editor, and CEO of Business Insider. Follow him on Twitter.

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