Mutual Funds Bear's Den
by Paul Larson ([email protected])

I am the type of Fool who likes to boil issues down to a few points that are as simple and as concise as possible. Boiling down all the facts about mutual funds reveals something interesting at the bottom of the pan once all the hot air and vapor are gone. That something is a single fact that is easy to understand and should make any investor think twice about putting his hard-earned cash into managed mutual funds. What's that fact? The fact is that more than 90% of all mutual funds have lost to the major market indices over the past five years.

Read that last sentence again. If there is one fact to bring home about mutual funds, it is that they generally underperform the market. And they underperform it badly, too. I'm sure my buddy Rick will point to the few that actually do beat the market in his case for funds, but there's no denying the odds. An investor blindly picking a mutual fund is going to pick one that underperforms the major market indices nine times out of ten.

I know this single statistic is almost unfathomable, but let's look closely at exactly why many of the managed funds perform so poorly. The first and probably most important factor to consider are the fees the mutual fund companies charge to actually manage money. Whether a particular fund is loaded or not, the company running the fund has to take money out to pay for fancy offices, sizable salaries, and spiffy television commercials. This money is coming from somewhere, Fools. Just remember, whenever you hand over your money for someone else to manage, in one way or another it is going to become a source of their income.

Size is also a major inhibitor to fund performance. With fund managers many times trading in denominations with five and six zeros (or more), it gets awful tough to trade stocks without having their own orders move the price of the stock they are trying to buy or sell. This is especially true when trading stocks of companies with small market capitalizations. Unlike the rest of the world, the stock market does not give volume discounts. In fact, it's quite the opposite; big buyers and sellers are forced to take a worse price than those working with smaller, more liquid quantities.

The size of many funds not only clips their nimbleness, it forces funds to own a great number of stocks. Most funds carry literally hundreds of different stocks in their portfolios, which is an awful lot of companies to track for any given manager. Let me suggest that an individual investor following a dozen companies or so is going to be much better versed in those stocks than even the sharpest manager attempting to track a hundred positions.

Furthermore, having so many positions makes actually beating the broad market that much harder. Simple statistics show that the more stocks there are in any given portfolio, the more likely that portfolio is going to resemble the market as a whole. (Read: tougher to outperform.) Many fund managers, whether they acknowledge it or not, are "closet indexers" whose performance closely mimics the market, minus their fees, of course.

Do you really want to put your money into investment vehicles with such major handicaps? I know I don't.

Let's also quickly mention the issue of control, or should I say, lack of control. By investing in an actively managed fund, you are handing control of your money over to someone else. The one rather important theme that runs throughout You Have More Than You Think is that handing control of your money to others is a bad idea. And given that most investors will never even come close to meeting those they are giving their money to, it's an especially bad idea here.

Have a moral problem investing in tobacco? Your fund may own a huge chunk of Philip Morris <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MO)") else Response.Write("(NYSE: MO)") end if %>. Can't fathom why someone would ever buy K-tel <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: KTEL)") else Response.Write("(Nasdaq: KTEL)") end if %>? It may be your manager's favorite stock. Want to minimize taxes by holding stocks for a longer period of time? Your manager may be a hyperactive trader. Do you have control over these issues when you invest in actively managed funds? Hardly.

Again, I think it all boils down to the simple point that the vast majority of mutual funds underperform the market in any given year. The numbers are simply too damning to ignore. Faced with this information, I find it difficult to believe that index funds or index-like investments such as S&P Depositary Receipts <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: SPY)") else Response.Write("(AMEX: SPY)") end if %> or Dow Diamonds <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: DIA)") else Response.Write("(AMEX: DIA)") end if %> are not more popular than they already are. For those not interested in managing their own money, such investments are just as easy and brainless as mutual funds, yet on balance they greatly outperform the actively managed fund.

As they say in Vegas, you gotta play the odds. And the odds say that managed mutual funds are a bad bet.

Next: The Bull Responds