How can you know if you’re choosing a winning mutual fund?

Mutual fund advertisements are the backbone of popular personal finance magazines. Mutual fund managers large and small love to brag. They will tell anyone and everyone when their actively-managed fund gets a “Five Star” rating from Morningstar. They’ll crow when it beats some well-known benchmark like the S&P 500. But how often does that really happen?

Comparing mutual funds

S&P Global has a research project to measure exactly that. They track all the actively-managed mutual funds in the USA. Actively-managed mutual funds are those in which the manager makes specific investments designed to outperform an investment benchmark. S&P Global compares these funds’ performances against the appropriate benchmark, and does so over multiple time periods.

The SPIVA U.S. Scorecard does not mince words. It’s ugly; really ugly.

For the past ten years, between 67 and 98% of all US active mutual funds have failed to match the returns of their benchmark. The low figure comes from large cap value funds (67.76%) and the high number from large cap growth funds (98.59%), but the bloodshed is really all over the landscape.

In the best performing asset class, actively-managed fund investors only stood a one in three chance of beating the index. That means at least two out of three times, these investors earned less than they would have if their fund was tied to market performance.

Lies, damn lies, and…

Another curious result of the study was the carnage among the funds themselves; of the 2,195 domestic stock funds in existence ten years ago, only 57% survive to the present day. What happened to the rest? Since most funds are owned by management companies with dozens or even hundreds of other funds, these failing funds were likely merged into other, more successful funds. This way the performance record of the dying fund disappears into the night. Ignoring the performance of dead funds ends up inflating the performance of survivors.

The problem with human nature is that we’re attracted to over-performers…and we buy in after the fund has out-performed.

The lesson of years of failed active management is that it is impossible to identify over-performers before the fact. Of course, anyone could get lucky, sometimes even more than once, but inevitably performance regresses back in line with the overall average. The problem with human nature is that we’re attracted to over-performers (like the successful active funds advertised in magazines), and we buy in after the fund has out-performed. The new investors, of course, get the regression back to the average. In other words, it’s called “buy high, sell low.”

So what’s a mutual fund investor to do?

An investor patient enough to accept market averages enjoys lower costs of ownership and almost always lower turnover and thus lower taxes. While investments in the stock market can and do lose money, over 10 year periods the market usually rises. When it does, the investor willing to accept what the market offers will undoubtedly outperform the mass of investors who believed they could outsmart it.