Wednesday, May 5, 2010

One Fools Fall In...Managed Funds?

By Jonathan Clements
September, 2002

Santa Claus and the Easter Bunny should take a few pointers from the mutual-fund industry.

All three are trying to pull off elaborate hoaxes. But while Santa and the bunny suffer the derision of eight year olds everywhere, actively-managed stock funds still have an ardent following among otherwise clear-thinking adults.

This continued loyalty amazes me. Reams of statistics prove that most of the fund industry's stock pickers fail to beat the market. For instance, over the 10 years through 2001, U.S. stock funds returned 12.4% a year, vs. 12.9% for the Standard & Poor's 500 stock index.

Moreover, fund performance is even worse than statistics like this suggest. How lousy are the results of actively-managed stock funds? Let us count the ways:

Mercy Killings

Almost all fund statistics suffer from what's called survivorship bias. Fund companies regularly kill off rotten stock funds, typically merging them into other funds with better records. That means these rotten performers disappear from the fund averages, thus making actively-managed funds look like a better bet than they really are.

For proof, consider some numbers from Vanguard Group in Malvern, Pa. Using the Lipper mutual-fund database, Vanguard calculates that U.S. stock funds returned 12.5% a year over the 31 years through year end 2001, compared with 12.3% for the S&P 500.

A clear victory for active management? Not quite. That 12.5% excludes all the funds that were liquidated or merged out of existence over the 31 years. If you add these funds back, you find U.S. stock funds returned 11% annually, or 1.3 percentage points a year less than the S&P 500.

The solution is to ditch actively-managed funds and buy market-tracking index funds instead. True, that means giving up any chance of beating the market. But with a low-cost index fund, you can be sure of garnering the market's result, minus maybe 0.2 percentage point a year because of the index fund's expenses.

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