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Many mutual funds sell investors a promise they don't even try to deliver on. Find out which funds to buy and which to avoid.
What percent of active mutual funds beat their benchmark over time? We'll show you the answer by fund size and category, and it may shock you.
We expose 6 major reasons mutual funds fail to beat a simple index over the long term and outline what you should invest in instead.
Mutual funds prey upon the uninformed investor.
They consistently offer poor performance (spoiler: it’s on purpose) and some participate in practices designed to mislead investors.
Before we dig into why many smart investors dislike mutual funds and what you should buy instead, let’s start with a simple definition.
A mutual fund is an investment product offered by a financial institution such as Vanguard, Fidelity, Charles Schwab, and many more.
Mutual funds pool together money from many investors and invest it in stocks, bonds, or other securities. Mutual funds typically have a style or objective, such as following the S&P 500, buying undervalued stocks, or tracking the health care sector.
Investors pay a management fee, called an expense ratio, which typically ranges from 0% - 2% (and above) of their total investment, depending on the fund manager, goals, and past performance.
Originally, the purpose of a mutual fund was to help small individual investors who didn’t have much money invest in large areas of the stock market.
For example, if you had $10,000 in savings to invest, it would be difficult for you to invest in the S&P 500 (you couldn’t buy 500 stocks) or track the entire energy sector (again, nearly 500 stocks). But with a mutual fund, you could easily invest $10,000 and get exposure to nearly any basket of stocks you’d like, no matter how large.
Now, to be clear, for most of this article we’re talking about ACTIVE mutual funds. These are funds that charge investors a relatively high management fee to try and outperform a relevant benchmark over time.
An example of an active strategy would be a mutual fund that charges a 2.0% expense ratio for investing in undervalued small cap stocks that will outperform the Russell 2000 small cap index.
On the other hand, PASSIVE mutual funds are a whole different story. They charge investors a small management fee (or no fee at all) to simply track an index, style, or sector without trying to outperform it.
An example of a passive strategy would be a mutual fund that charges a 0.1% expense ratio to track the S&P 500 index.
The right passive funds can be great for investors who want a “set it and forget it” investment option.
It’s the high-fee active funds that we (and other investors) are worried about.
According to Morningstar, interest in mutual funds has been lagging interest in exchange-traded funds (ETFs) for years.
As you can see, annual organic growth in mutual funds has been flipping between negative and barely positive, whereas growth in ETFs has been in the double digits for a decade.
In addition to jumping to ETFs, investors are ditching nearly all active mutual funds, except for the cheapest 20%.
Starting in 2014, there were large net outflows (investors removing their money) from all but the 20% of active mutual funds with the lowest fees.
Investors are voting with their feet. They have lost interest in expensive active funds and are moving their money to low-cost active funds or ETFs.
According to the Dow Jones SPIVA Scorecard, these outflows (plus consistent underperformance) have caused many mutual funds to shut down.
“Funds disappear at a meaningful rate. Over the 15-year period, 58.58% of domestic equity funds, 53.66% of international equity funds, and an average of 52.16% of all fixed income funds were merged or liquidated.”
So, why are investors abandoning active mutual funds?
Well, there are a six major reasons active mutual funds are often viewed as an inferior investment.
The biggest reason many investors don’t like mutual funds is that once you consider fees almost none of them perform better than a simple index.
For example, look at this absolutely stunning chart from the Dow Jones SPIVA Scorecard which measures the performance of active mutual funds compared to their benchmarks....