Buy ETFs, Avoid Mutual Funds

The Wall Street Journal reported on December 3, 2007 (Section R1) some interesting information in an article titled "Winning Funds Share Traits, But the Trick Is Finding Them." The article attempts to help mutual fund investors determine what characteristics a mutual fund had before it began an 8 year streak of beating the S&P.

We started by identifying a group of mutual funds with the longest winning streak against a well-known measure -- eight straight years of beating the Standard & Poor's 500-stock index. Only 30 U.S. stock funds made the cut, out of 1,935 eligible funds tracked by Morningstar Inc. Then we asked Morningstar to crunch the funds' data from 1998, as the streaks were set to begin....Along the way, we also noticed ...five of the seven focused on natural resources, such as oil, that were beaten down in 1998 but have boomed since. The lesson? Be willing to invest in categories that have been out of favor, since they may be due for a resurgence.

Kudos for the Wall Street Journal for helping investors attempt to find the 1.3% of mutual funds that had this kind of streak! But come on -- what a useless bet to take. The "trick" is to stay away from them.

Let's see, I can:

1. Try to beat the market. Take my chances that I can identify the 1.3% of the funds that will beat the S&P . If I do find one of the funds in the top 1.3%, I'll beat the S&P by a few points. But if I fail to identify one of those top 1.3% of the funds, I'll probably lose 2% a year for 8 years which will deteriorate my capital by 20% over those 8 years compounded.

2. Buy an index fund or ETF and match the market with 100% probability without paying much tax.

According to the article:

In 1998, the average large-blend fund in Morningstar's overall database turned over 62% of its stocks each year. Several of the large-blend funds on our list came in comfortably under that level. Currently, the average fund in Morningstar's large-blend database turns over 72% of its shares annually. Most of the seven large-blend funds on our list continue to trade less frequently than their peers.

If we assume half the normal turnover, the tax bill will eat you alive even if they do beat the market. Since the study only describes pre-tax returns I'll bet another 10 - 15 of those funds don't beat the S&P.

I think the odds of beating a roulette game by spinning the dice 2000 times and picking random numbers from the Keno board are better.

To the Wall Street Journal: Great article, wrong conclusion.

The right conclusion? Stay away from mutual funds and buy index funds or ETFs.

Comments

[skorpio:]

Now, of course---the trick is to get into the right mix of ETFs.

2008 Jan 20 01:26 PM

[skorpio:]

Now, of course---the trick is finding that perfect blend of ETFs.

2008 Jan 20 01:27 PM

[gokou3:]

The 1.3% is slightly misleading IMO. We don't need a mutual fund that beats the market EVERY YEAR for x years. All we need is a fund that beats the market ON AVERAGE over long-term. The chance of finding latter is much higher than 1.3%, but is still exceedingly small (~20% from some articles I read).

2008 Jan 20 03:06 PM

[oldman:]

I am very happy with a mix of funds I have and have no idea which ETF's can accomplish what my funds have done. Largest positions are:
OAKBX
SGENX
PRPFX
LCORX
BJBIX
RYPRX

2008 Jan 20 08:18 PM

[A.S.D.:]

There are no true ETFs for the new emerging (Africa/middle east) markets, only one fund : TRAMX. Several ETFs are in the works, but,...who knows in this market.

2008 Jan 22 11:18 PM