The Real Reason Why Mutual Funds Underperform

Last update on Feb. 18, 2014.

Big ship stranded

The bigger the ship, the slower they turn. This phenomenon partly explains why mutual funds underperform.

 

"My mutual fund returned 15% last year. That has to be higher than normal, no?"

One of my readers asked me this question recently, to which I told him that actually, it's not that impressive.

If you've been following the financial news closely, you'll have known that the stock market, especially the U.S. stock market, especially in terms of Canadian dollars, had a gangbuster year.

If you had half of your money in a U.S. stock ETF, and the other half in a Canadian stock ETF, you would have returned around 26%. If you had 20% of your money in short term bonds, and the rest split evenly between U.S. and Canadian stocks, you have returned around 21%. (In case you're wondering, MoneyGeek's portfolios didn't achieve that last year because it wasn't operational until mid March).

Our reader's mutual fund performance would only be impressive if it returned the 15% without taking on very much risk. While this is possible, I somehow doubt it.

In fact, as many people have pointed out, mutual funds have consistently underperformed the overall market. Which leads us to ask, why?

I've dealt with this topic briefly in my free book, but in this article, I will go into it in more detail.

Shouldn't There Be A Tiger Woods Of Investing?

As I've mentioned in the book, investing is a zero sum game. In other words, anytime someone outperforms the market, another underperforms the market. It's like how in a golf game, half the players score above the average score, while the other half scores below the average. You can't escape this mathematical reality.

However, that's the performance of the funds before fees. So before fees, the average mutual fund performs as well as the market. But after fees, the average fund performs worse by the amount of fees. For example, if mutual funds charge 2.5% per year on average, then the average fund underperforms the market by 2.5%.

However, this raises up a big question. While we now understand why the average mutual fund underperforms, isn't it possible that a particular fund can consistently outperform the market? After all, Tiger Woods always seem to come out ahead of the average golfer. Shouldn't there be a Tiger Woods in the mutual fund industry?

It sounds plausible. If investing is a skill like any other, it means some people are better at it than others, so you'd expect to see mutual funds that outperforms their peers almost year after year.

However, there's one big problem. When you look at the data, you don't see it.

Very few mutual funds seem to outperform the market over the long run, and you can brush off the ones that do as being lucky. Have enough people flip coins, and you'll have someone who flipped heads 10 times in a row.

So what's going on here? One possible explanation people have put forward is that the markets are "efficient". In other words, stock prices always accurate portray the true value of the stock themselves. According to this theory, you can't beat the market except by chance. However, I strongly disagree with this theory, for reasons outlined here.

Thankfully, there IS another explanation. Some researchers have recently investigated why mutual funds that outperformed in the past haven't continued to do so thereafter, and found some convincing results. Basically, it boiled down to two things: mutual fund size, and management changes. Let me explain each of these.

Size Is A Disadvantage

When it comes to managing money, size is a big disadvantage. In other words, the bigger you are, the tougher it gets.

For example, if you run a tiny fund with a million dollars, you can invest in virtually anything, and it will "move your needle". With a fund that small, just $100,000 investment represents 10% of your portfolio. You can easily take a $100,000 position in virtually any public company. You can take a position in Apple, or you can also take a position in a junior mining company worth just $50 million. Either way, if the investment does well, the benefit is significant.

However, if you run a big fund worth a billion dollars, you can't just invest in anything. For example, even if you're convinced that the $50 million junior mining stock will double, you probably won't bother looking at it. Why? Because with a $50 million company, you might only be able to get, say, $2 million position on the company. Well, $2 million only represents 0.2% of your fund, so even if it doubles, you only gain another 0.2%.

Therefore, if you run a big fund, your universe of investment worthy stocks shrink drastically. You're suddenly only limited to buying and selling the few hundred biggest companies in the world. Moreover, because the selection is limited, you'll find that these stock have been combed over by other funds as large as you. It's like graduating from your local golf league to the PGA. The competition becomes fierce, so it gets harder to outperform.

So let's say that you run a fund that performed very well, not just this past year, but for several years running. What happens to the fund? Well, among other things, it becomes popular. People chase returns, so the fund's size grows. But even if you don't take in new investors, the fund's size grows anyway because by definition, good performance grows investments.

Great Managers Don't Stay

But even when they become big, it's reasonable to expect that some mangers will do better. After all, Tiger Woods isn't just the best in his local neighbourhood. He's consistently one of the best, even against tough competition. Surely, some mutual managers can do the same?

The short answer is, yes. However, there's a problem - those managers don't stay.

As I've mentioned in my book, star fund mangers often jump ship to hedge funds, for the simple reason that they get paid more. Mutual funds charge 2.5% per year. Hedge funds charge 2% per year, and 20% of profits. On a year like last year, if you ran a U.S. stock market hedge fund, you would have charged roughly 7% in fees, even if you did as well as the market before fees. It's way more lucrative to run hedge funds than mutual funds.

Since the Tiger Woods of investment managers run hedge funds, should you invest in hedge funds instead? Not so fast. While some hedge fund managers are more skilled than mutual fund managers, the gains from more skill are often vastly outweighed by the heavier fees. For example, last year, a U.S. stock hedge fund would have had to outperform the market by at least 8% for its investors to receive market average performance. That's a tough hurdle!

Anyway, coming back to why mutual funds underperform, the two factors - increasing size and managers leaving - explain why mutual funds fail to outperform consistently from year to year.

Conclusions

So what happens if size and management stay the same? Well, the researchers of the study I previously mentioned show that if they were held the same, the mutual funds that outperformed in previous years tend to outperform in the future by 4% per year. In other words, some managers ARE better than others.

Sadly, in the real world, good mutual funds do get bigger over time, and managers do jump ship to start hedge funds. That's why unfortunately, I believe most mutual funds will underperform the market after fees, and it's why I think believe index funds and ETFs will outperform them in the long run.

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