Managed Mutual Funds - "Pay Me to Underperform"

There is no shortage of ways to invest your money to earn a return: real estate, bonds, T-bills, CD's, casinos, and so on. In this article, though, we have decided to invest in the best performing asset class throughout history: common stocks of publicly traded businesses.

The first question most investors ask is: where should I put my money? There are thousands of U.S. traded stocks alone, not to mention the insane variety of international stocks, mutual funds, exchange traded funds (ETFs), etc. It can all be extremely intimidating for the new investor, which is of course part of the point. If Wall Street made it simple, what motivation would you have to pay a money manager take your money and invest it?

The fact is, a satisfactory return can be earned with an absolute minimum of cost in both time and money. Several brokers offer what are known as indexed mutual funds. Some of the most popular, such as Vanguard's S&P 500 Index (VFINX), track the return of wide ranging stock market indicies. Since over a very long period of time this stock market index, representing nearly 80% of all companies, returned about 10% a year, this is not a bad way to invest.

So, you know you can match the market's returns very simply. However, wouldn't it be nice to beat the market and build your nest egg faster?

Such is the thinking when buying into a managed mutual fund. In contrast to indexed mutual funds, which are mechanical and follow a predefined index with no variation, managed mutual funds are run by a team of stock pickers headed up by a manager. In the quest to beat the market and get rich quicker, investors willingly pay for the expertise of professional management. There can be several reasons why. Perhaps the manager has had an excellent historical track record of delivering market beating returns. Maybe the investor lacks the knowledge or confidence to invest on his own but still desires to outperform the S&P 500. Whatever the reason, a massive amount of money flows into these managed funds. In the middle of 2008, they controlled over 20 trillion dollars of investor capital.

Obviously, you pay for the privilege of professional handling of your money. Managed mutual funds charge what is known as the "expense ratio" every year. The expense ratio covers things like paying the management team their salary and bonuses, advertising the fund to new prospects (known as 12b-1 fees), fees to lawyers, expenses for shareholder communication, and so forth. For many managed mutual funds, this charge can be 1-2% per year.

The costs don't stop at the expense ratio, however. Some funds charge what are called "loads". A "front-end" load is a percentage charged to your investment when you buy into the fund, and a "back-end" load is charged when you want to withdraw your money from it. Also, you have no control over when taxes from trading are charged. If a fund manager trades in and out of stocks often, you will be paying full income taxes on any short-term gains. Since income tax is more than double capital gains taxes, this is another expense that has to be accounted for.

With all these expenses to overcome, the fund manager has to deliver market outperformance for it's clients to even match the index's return. Surely, however, these professional money managers can outperform a simple index like the S&P 500, right? If they couldn't, why would people pay them when they can easily match it with an index fund?

Sadly, the large majority of managed mutual funds underperform the S&P 500, after fees. It's not even close, either - in an average year, as much as 80% of these mutual funds are underperformers. According to Vanguard founder John Bogle, from 1984 to 2002 mutual funds delivered a 9.3% annual return. That seems decent, but when compared against the S&P 500's return of 12.2% a year, it's not good. A lot of investors are paying a lot of money for managers to underperform the market.

Another disadvantage is deciding what fund to buy. Unlike common stocks which rise or fall with the fortunes of the underlying company, managed mutual funds are impossible to value. Historical and comparative data make it possible to reasonably decide a good value for a stock, but the price of a managed mutual fund is almost abstract. Since the assets of the fund can change daily, there is no way to tell if the current fund price represents a bargain or a fleecing. Past performance and star managers are not good measures, either. Consider Legg Mason Value (LMVTX). The fund beat the benchmark S&P 500 index for 15 years in a row up to 2005, and has a famous manager in Bill Miller... but has subsequently underperformed by a staggering 15% per year since.

Fortunately, there are alternative stock strategies out there that beat the market, and do so with a minimum of cost in both time and money. You don't have to be a stock analyst, or indeed know anything about stocks, to use them - just buy the stocks from a statistical list. Several of these strategies exist, but the most impressive was Joel Greenblatt's Magic Formula Investing strategy, which nearly tripled the market's annual return over a 17 year period.

However, statistical strategies can often dig up undesirable companies whose past success is unlikely to continue into the future. Due diligence is needed to weed out the truly great companies from the undesirables.

By adding some MagicDiligence to the mix, you will be buying only stocks with strong underlying businesses, giving you the best chance to beat the market while weeding out the undesirables. So far, combining the Magic Formula with MagicDiligence has resulted in investment performance far exceeding the S&P 500, the unaltered Magic Formula strategy... and managed mutual funds as a class. Start a free 30-day trial today!