Investors should be leading Occupy Boston

That city is home to a mutual fund industry built on selling products and collecting fees while delivering unimpressive returns.

By MSN Money Partner Oct 12, 2011 10:54AM

Image: Mutual funds (© ThinkStock/SuperStock)By Rick Ferri for Forbes.com

 

Mutual fund investors should take the lead to “Occupy Boston,” a grass-roots protest that has stemmed from the popular Occupy Wall Street movement.

 

Boston is the birthplace of mutual funds and exchange-traded funds (ETFs) and the home of huge mutual funds firms, including Fidelity, MFS, Eaton Vance and Putnam. The mutual fund industry takes billions of dollars in fees from investors every year and routinely deliver truly unimpressive investment performance. It’s time to take this message to the streets.

 

The mutual fund industry isn’t about investor prudence, it’s about product sales. It’s about sensational launches of hot new funds on Main Street, while quietly burying sick and dying funds in the back alley. It’s an industry that never met an idea it didn’t like -- if the public would buy in -- even when there was no reasonable expectation that investors would earn money. Fund churning and burning has accelerated over the past few years with the proliferation of exchange-traded funds (ETFs).

 

A fund for every sales pitch

There is about three times the number of U.S. equity mutual funds on the market today compared to 20 years ago. During this same period, the number of companies listed on a U.S. exchange fell by 40%. The vast majority of these mutual funds are less than 20 years-old, according to Morningstar Principia.

 

Companies close funds as fast as they open them. The closure rate, as a percentage of funds outstanding, has nearly doubled in the past decade. About half of all U.S. equity mutual funds have closed in the past 20 years. How can this industry claim that they are delivering long-term investor value when there is a 50% chance a fund will close over the next couple of decades?

 

Fund turnover is only half the story. Poor performance of surviving funds is the other half. Only one-third of the surviving equity funds beat a comparable equity index. Bond funds have been worse, with one-fifth managing to outperform.

 

Of the funds that do outperform, it isn’t by much. Only a handful of winning funds beat the market by an amount that investors expect. Figure 1, from my book "The power of passive investing," is a breakdown of performance based on 100 funds. This data is presented before deducting any sales commissions, advisor fees or taxes.

 

It’s hard enough to pick a fund that will survive for 20 years, let alone picking one that will outperform. That being said, there are plenty of investor services that claim to know which funds will be the winners of the future and they have the slick marketing material to prove it. Travel at your own peril.

 

Figure 1: 20 years of active equity funds (based on 100 funds)

 

Are you ready to Occupy Boston yet?

 

Twenty years of data is a long time, so here are some five-year numbers. Figure 2 shows five-year averages that span several decades and combine several equity asset classes. The figure separates funds into five equal buckets, based on status and trailing performance, versus appropriate indexes.

 

Fig. 2: Five-year equity funds based on status and relative performance against indexes

Forbes.com

This tells a familiar tale about the mutual fund industry. Over 5 years, about 20% of actively managed mutual funds are shut down, 40% will underperform a comparable benchmark by a considerable amount, 20% land around the benchmark and only 20% of products will outperform by a worthwhile amount.

 

A closer look at Figure 2 reveals another performance problem. This one that is often swept under the rug by the industry and overlooked in the media. Here’s the issue. The dead funds, the bottom funds and the third category underperform the benchmark by 2.5% on average. The 20% that beat their benchmark did so by only 1.4% on average. That’s a whopping return disparity between the 60% of at the bottom and the 20% at the top. Even if you’re lucky and pick a fund that’s in the top 20%, the return isn’t nearly high enough make up for all that downside risk.

 

Boston is failing us.

 

The answer: Low-cost index funds

There is an alternative to Boston. It’s Malvern, Pennsylvania. That’s where the Vanguard Group is located. They are the founders and leaders in low-cost index fund investing. Indexing is the best way to ensure you are getting your fair share of return, without the risk of active management.

 

Investors are dumping Boston and heading for Malvern, en masse. They are switching out of churn-and-burn active fund companies and are moving their money into low-cost index funds that match the returns of the markets, less a tiny fee. It’s about the realization that achieving a good investment return is better than hoping for a great one.

 

To be fair, Vanguard isn’t the only company promoting low-cost indexing. Ever since John Bogle created the first index for individual investors in 1975, this alternative to active management has become popular with investment companies from New York to California and from Chicago to Austin, and yes, even in Boston.

 

Indexing is done by creating a very low-cost portfolio of stock and bond funds that match your personal circumstances. It involves massive diversification so that you don’t get nipped by bad manager decisions. The result is a simple strategy, lower risk and higher returns for you. 

   

Forbes contributor Rick Ferri is an author, advisor and speaker on low-cost passive investing.

 

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