At the risk of offending everyone I know over the age of 60, it's time to go public with an unpopular investing truth: If you own mutual funds, you're likely getting punked. (You know, that show where the good-looking guy...or is it ex-guy... plays candid camera tricks on celebrities?) Alright, maybe not exactly punked, since no one but your broker has to know about such indiscretions, and she's not likely to publicize them. Mutual funds fall in a long line of "hot" investment strategies: buying on the margin, the nifty fifty, junk bonds, leveraging with junk bonds, tech stocks, derivatives, and of course, the mutual fund industry's once universally lauded counterpart, the 401k.
My first experience with mutual funds began with the 401k plan offered by my first real employer. Perplexed by the variety of funds to choose from, I decided to enlist the help of my normally level-headed father. His response took me aback: "Oh, it doesn't really matter; the important thing is that your employer will match your contributions." (Did I mention this was awhile back?) Even though I chose mostly international equity funds, which shows just how much I knew about investing, in the end, my father's advice proved correct-it didn't matter. After a few years of breaking even, I cashed out, penalties, taxes, and all. Then, I forgot about investing.
Years later, having saved a small amount of money, I reconsidered. This time, I asked my father-in-law for advice. He suggested "a base of mutual funds" but felt compelled to add, "I'd wait until the end of the year when the market sugars out." While I can't be positive, I'm pretty sure he wanted me to delay until stocks had rebounded from their 2,000 point slump in 2007. But why would I wait until prices go UP to buy?
Dismayed by the counsel of two of the most financially secure people I knew, I turned to Google. There, I discovered Ben Graham's investing classic, "The Intelligent Investor." Finally, I'd found the enlightenment I'd been searching for. I followed up with even more books, many about the man who authored the forward for Mr. Graham's book, Warren Buffett.
Mr. Buffett, I learned, isn't particularly fond of mutual funds either. A valid point of contention centers on the fact that many fund managers reap large fees regardless of their fund's performance. Not to mention, this configuration strongly encourages a herd mentality. Afraid of looking stupid, mutual fund managers tend to copy one another. Therefore, on the whole, investment decisions of a mutual fund manager are based upon the relative popularity of a company rather than the underlying economics of the business.
Ready for the real kicker? Research indicates that at least 80% (some studies say more) of professional fund managers fail to beat market averages. According John C. Bogle, actively managed funds, on average, fail to outperform appropriate market indexes even before fees are deducted (70-71). Why then, would investors stick with traditional mutual funds when owning a low cost index fund is the more profitable alternative? Perhaps they have fallen to the same herd mentality as mutual fund managers.
Baby boomers, in particular, seem to hold mutual funds in unusually high regard. Remember "The Wealthy Barber," that clever and infectious tale about the town barber who dispensed investment wisdom as if he came directly from Mt. Sinai itself? These "commandments" resonated strongly with boomers raised on depression era values such as "Don't put all your eggs in one basket." While diversification is certainly a sound strategy for passive investors, it was another concept altogether with which the Wealthy Barber led his flock astray: "The fund I used had a high commission structure, but it has been well worth the cost." Research suggests otherwise.
In 1998, one third of all index funds carried either front-end or asset-based sales charges, (133) illustrating the prevalence of the belief among index fund investors that you "get what you pay for." In his book, Common Sense On Mutual Funds, Bogle questions the willingness of investors to pay fees, "Why an investor would opt to pay a commission on an index fund when a substantially identical fund is available without a commission remains a mystery."
Fees matter. Over the course of an investment lifetime, the gap only widens. Of course, none of us would mind paying more for truly exceptional results, but what are the chances of finding such a fund? John C. Bogle enlightens us by drawing upon one study in which only 12 of 258 general equity funds were able to beat the market by a statistically significant margin. Bogle writes: "The 12 winners could not have been easy to identify in advance... Despite their acknowledged past successes, no one can be sure of the extent to which it may recur in the future, whether or not their managers stay on the job or retire and rest on their laurels. Today, could investors be highly confident of superior returns if they selected one of the four legitimate fund champions that remain open to investors? It would seem, at best, a counterintuitive decision for the intelligent investor." (215)
Still not convinced? Go to msn.money.com to compare your mutual fund's performance to the S&P500 index. Should you find that you're losing out to the market year after year, isn't it time to make a change? Well, maybe you'd better wait until things sugar out.
Bogle, John C. Common Sense on Mutual Funds. New York: John Wiley and Sons, Inc, 1999.
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