ETF Investing Guide: Why You Shouldn't Buy Mutual Funds

by: David Jackson

For many people, the natural candidate for a core investment strategy is the purchase of mutual funds. With mutual funds, you can build a diverse portfolio of stocks and types of stocks cheaper than buying the stocks yourself. But the truth is that the majority of mutual funds don’t beat the market, and their track records are distorted by survivorship bias. Did you know that mutual fund companies are allowed to merge a badly performing fund into a smaller but better performing fund, and claim the superior historical performance for the combined entity?

When you take fees into account, the picture gets a lot worse. According to a Wall Street Journal article on January 15th, the median expense ratio for diversified stock funds increased to 1.46% of assets in 2002 from 1.37% in 2000. And in addition to the fees that mutual funds charge as a percentage of assets each year, you also need to factor in the trading costs the funds bear as they buy and sell stocks, and the capital gains they distribute to you when they sell stocks that have appreciated.

In aggregate, after fees, trading costs and distributed capital gains taxes, most mutual funds significantly under-perform the market indexes. In their book The Great Mutual Fund Trap, Gregory Baer and Gary Gensler estimate that at the end of 2001 the 1,226 actively managed mutual funds that were around long enough to have a 5 year record trailed the S&P 500 Index by 1.9 percentage points a year on average, and the 623 funds around long enough to have a ten-year record trailed by 1.7 percentage points a year.

These numbers include upfront and back-end fees (loads). Yet even excluding the loads, the average five-year and ten-year returns trailed the S&P 500 by 1.4 percentage points. And those numbers apply only to the survivors; the funds with truly abysmal returns were, in many cases, merged out of existence. Correcting for this survivorship bias, Baer and Gensler estimate that the average actively managed mutual fund trails the market by about 3 percentage points a year.

Three percentage points a year! To put that in context, the S&P 500 fell by about 0.6% annually over the 5 years to 2003. And note that the three percentage points underperformance of mutual funds is worse than the two percentage points underperformance of individual stock-picking investors.

This finding, incidentally, is corroborated by Vanguard’s research which found that people investing in mutual funds in their 401K accounts typically hold 70% stocks and 30% bonds and lag the appropriate benchmark by about two percentage points a year. I guess bond funds have lower fees, and people switch into and out of funds less frequently in retirement accounts.

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