Picking a hot mutual fund is a long shot

You have nearly an equal chance of being hit by lightning as finding a fund that is a top performer for 5 straight years.

By MSN Money Partner Jul 24, 2014 12:21PM
Image: Mutual funds © ThinkStock/SuperStockBy Mitchell Tuchman, MarketWatch

Do you know someone who has been hit by lightning? Do you know anyone who knows anyone who has been hit by lightning?

Exceedingly unlikely, right? But it turns out to be roughly the same chance as knowing someone -- anyone -- whose mutual fund consistently stays ahead of the pack.

Put another way, your chances of buying a hot fund and watching it immediately lag are pretty darned high. Close to guaranteed.

This fact shouldn't surprise anyone. A study by S&P Dow Jones Indices, reported in The New York Times, showed that just two funds out of 2,862 managed to be in the top quartile of performers for five consecutive years.

The two funds in question -- the Hodges Small Cap (HDPSX) and the AMG SouthernSun Small Cap (SSSFX) were small-cap funds (also not surprising), but SouthernSun is closed to new investors. So you're down to one choice out of 2,862. Your chances of being hit by lightning in your lifetime, meanwhile, comes in at 1 in 3,000.

Crash helmet

Let's say you're one smart cookie. You can somehow figure out in advance which fund will be the one that outperforms. Now, are you ready to dump your retirement savings into a small-cap fund and forget about it for years? 

Yes, small caps outperform the broader stock market, but you'd better buy a crash helmet for the ride. By one measure, small-cap stock funds deviated from their average value by as much as 38.6 percent. That means you could be nearly 40 percent higher and, yes, 40 percent lower than the long-term average small-cap return. 

You do need small-cap exposure, but it should be part of a well-designed portfolio. Over 10 years ending 2013, small-cap fund returns averaged 9.12 percent, according to Morningstar data.

Comparatively, cautious portfolio investors saw a similar result, but with far less volatility.

All of this leaves aside the cost of actively managed funds. The one fund reported in The New York Times that remains open, at least at this writing, charges a gross expense ratio of 1.39 percent. For comparison's sake, a Vanguard small-cap index fund costs 0.24 percent.

Sure, you get "only" the index return and, yes, the recent multiyear performance is lower for the index fund. But now you must own the 1-in-3,000 hotshot fund or face the music. Most of the also-rans will lag the index badly.

Let's assume an active small-cap mutual fund that you buy has a comparable fee and somehow keeps up with the industry average of a 9.12 percent return. Assume that the index fund posts the same gains.

Lottery odds

Over 10 years, you will pay $2,078.65 for the active fund and $377.99 for the passive fund. Put another way, a $10,000 investment held for 10 years in the active fund has generated $10,788 for you and put $2,079 in the pockets of the fund manager.

The passive option, meanwhile, has reinvested more of your money, creating a profit of $13,368 for you and putting just $378 into the coffers of the fund operator.

Lottery odds are worse by far, but the modern mutual fund industry has turned into what amounts to a lottery for "smart" people.

It's easy to sneer at the gas-station ticket scratchers, yet a surprising number of people buy high-cost active funds that can't keep up with the very markets they are supposed to beat.

Who knows? Maybe there's a market for personal lightning insurance.

More from MarketWatch

Jul 25, 2014 10:50AM

"...but the modern mutual fund industry has turned into what amounts to a lottery for "smart" people."


Oh pull-eeze. There is nothing 'smart'...at all...about any of this 'investing' crap. I can flush my own money down the toilet, than you.

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