Is your mutual fund advisor stringing you along with a lie? Are you getting the facts, or a skillfully staged show full of smoke, mirrors, and misdirection?
If you decide to invest in mutual funds, it’s very important to do your research and not blindly follow your advisor’s advice and claims.
Here are some of the most common myths and questionable practices surrounding mutual funds, and how you can combat them.
Mutual Fund Myths
1. “Mutual funds perform better than stocks since they are managed by experts.”
No, in general, mutual funds and stocks perform almost exactly the same. In a December 2009 draft of the paper, Luck versus Skill in the Cross Section of Mutual Fund Returns, Eugene Fama and Kenneth French report that between the years 1984 and 2006, mutual fund investors receive net returns that under-perform benchmarks by about the cost in expense ratios.
With that said, some managers do indeed have enough skill to warrant their expense ratios. However, the point is that just because someone is a fund manager, it doesn’t mean that they can beat an average market return. You need to do just as much homework into your fund manager as you would a company in which you would invest.
2. “Mutual funds are ‘safer’ than stocks since they diversify risk across many assets and are managed by professionals.”
A mutual fund is not necessarily a “safer” investment. It is true that a large basket of diversified stocks in a variety of industry groups or sectors can provide less volatility. But a mutual fund is not the only way to lower volatility from your portfolio. You can reduce momentum by simply purchasing stocks in a variety of sectors, or picking from groups of slowly moving dividend paying stocks, such as some utility companies. If you have the time, learn how to use online tools from stock investment research sites to screen for companies that have low volatility and low beta, yet good price performance.
You also need to ask how your advisor quantifies “risk.” Is it by overall performance? Is he looking at maximum draw-down? What about monthly or annual volatility? Ask about the Sharpe ratio which gives a reward-to-variability metric. A higher ratio indicates a stock that performs better relative to the amount of risk it takes on. Go one step further and instead of analyzing this ratio in isolation, look at a group of similar and highly-correlated funds (e.g. small-cap energy funds) and choose the highest relative Sharpe ratio in the mix.
3. “Actively managed funds are better than passive ones since your advisor can time the market in addition to aggressively buying and selling.”
An analysis of fund performance in the paper, On the Timing Ability of Mutual Fund Managers (2000), found that some market timing ability was evident in some managers on a daily basis. But the problem is discerning these particular managers from the rest of the pack. Moreover, broad average studies, such as those in the paper, Mutual Fund Performance (2006), show that while actively managed funds might slightly outperform other funds when looking at gross returns, the high transaction costs and investment management fees make these gains negligible.
In other words, market timing ability is not guaranteed when buying an actively managed fund, nor is it even evident in most of them. Further, you’ll pay more to be in an actively traded fund which will diminish potential returns.
4. “Sure, the management fees are higher than average, but that’s like buying insurance. You get what you pay for.”
While the relationship between management fees and performance is mixed, there seems to be little if any evidence showing that higher fees are linked to better performance. The real debate is whether higher fees have a negative correlation to performance or whether there is any relation at all.
Multiple studies, including The Determinants of Mutual Fund Performance: A Cross-Country Study (2010) and Mutual Fund Performance (2006), all point to the same conclusion: There is almost no difference between the performance of no-load, low-load, and high-load funds. In other words, don’t be bamboozled into thinking that simply paying more means you are getting more.
5. “The average annual return on that fund is…”
Showing you the Average Annual Return (AAR) is not necessarily misleading, but an improper analysis of the number can be. Look to the annual compounded return and not the simple average of the annual gains if you want to see what you would’ve made in the fund had you been invested.
Here is an example of my fictional fund and why you should use compounded numbers:
- Year 1: +100%
- Year 2: -50%
- Year 3: +100%
- Year 4: -50%
It looks like you should be up 100% if you simply add and subtract all the columns. If you divide this by four years, it appears you have a simple gain of 25% per year. But this is quite wrong. Imagine you invested $1,000 dollars in year one. You double it to $2,000. Then, it falls in half to $1,000. You double it and half it again to end up with your original investment. In the end, you gained nothing, which is a far cry from 25%.
To get a true sense of past performance, look to the average annual compounded gain. If your mutual fund advisor tries to give you the average annual return figures, ask to see the compounded annual returns instead. And if they balk at this for any reason, find a different advisor.
6. “This fund beat the market benchmark by a lot.”
Benchmarking is a common tool to see how well a fund outperformed a certain group of stocks. For example, a certain small cap value fund may have risen 60% from July 2009 to July 2011. Compared to the Dow Jones Industrial Average, which only rose 45%, it seems that this fund is a winner. But is your advisor comparing apples to apples? Wouldn’t it be better to use the Dow Jones U.S. Small-Cap Value index as a benchmark? If you saw that this small-cap value index rose 70% compared to the highly touted fund that rose only 60%, you might realize that the fund which looked full of steam one minute ago is really just full of hot air.
Be aware of whether your fund is small, mid, or large cap. Know also whether it is a value or a growth fund. Then ask to see an appropriate index that is a true benchmark for your type of fund. Visit this market performance site that benchmarks equities to compare your fund’s performance. You can quickly find out how well a broad portfolio of small-cap growth stocks did over the past 3 months, or by what amount a basket of large-cap value stocks rose or fell during the past year.
7. “Look at this great performing chart for this fund. You want to invest with this fund family.”
This one is a mixed bag. There is actually some truth to the idea that a past winner will be a future one as well. Both abstracts, Mutual Fund Performance and The Determinants of Mutual Fund Performance: A Cross-Country Study, agree with the theory that past performance does carry an indication of future performance. That said, this phenomenon is the strongest with poorly performing funds. You should absolutely avoid the worst performing funds as history shows that they typically post poor price performance in following years. If the advisor is trying to sell you a fund because of its strong performance, there is nothing wrong with this.
On the other hand, the mutual fund advisor may have cherry-picked this fund’s chart and may be hiding other lackluster funds by the same family name. A family of funds is like a dynasty of medieval kings; they like to tout their successes and bury their losses. You can try to get aggregate data for a family of funds online, but there are survivor-ship issues which means discontinued funds are not likely to show up anywhere in your results. There may be little you can do about your advisor hand-picking the best fund of the group. Just be aware that he may not be giving you a chart that shows typical performance for an average family fund.
Let me be clear. I don’t think mutual fund managers are evil or that they are a group of thieving crooks. There are managers out there that smartly pick stocks and know when to buy and sell them. But these fund managers are the exception and not the rule. If you want to randomly pick a mutual fund because you think it is an easy way to beat the market, think again. But if you are willing to research the fund manager, realistically analyze the compound rates of return, and compare the fund to its appropriate benchmark, you’re much more likely to see investment gains. Also understand that funds, like stocks, on average don’t outperform the market.
Are you invested in mutual funds? How did you go about choosing the fund and how has it performed so far?