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What Every Investor Should Know About Planning And Saving For Retirement
So this first Vlog in our Investment Education Series is actually going to be about mutual funds and specifically talking about Why More Mutual Funds Are Not Able To Beat Their Underlying Benchmark Index.
I’ve seen numerous statistics and studies about this, Morning Star does a study on this every year. But some recent research from Standard & Poor’s looked at a five year time period ending December 31, 2016. And over that five year time span, they determined that about 88% of large cap mutual fund managers failed to beat their underlying benchmark index. So that’s a huge number and with that number it’s no surprise that many people are abandoning this active portfolio management in exchange for passive index-based investments. In fact, another article on Yahoo Finance recently titled Analyst Sounds the Alarm On What Could Be the Most Crowded Trade in U.S. History, and he was actually trying to warn people a about putting more money into index-based investing. But he actually cited that since 2007, approximately $1.1 trillion has flowed into these passive index-based investments. And at the same time period about $835 billion has flowed out of active portfolio mutual funds. Those are some huge numbers, and I think something we’re going to be talking about later in this video series is why you might want to be a cautious about that. But here’s why I believe mutual funds may underperform their benchmark index. I think there’s three reasons.
Number one is that managers are inconsistent and unpredictable. And again this will be something we’ll talk about more in the rest of this series. I’m going to be talking about why humans may be predisposed to making poor investment decisions. But really if we’re looking at a track record of a mutual fund, it’s very important for us to understand how that manager built that track record. In other words, what was the strategy they used to achieve that, and are they going to be applying that same strategy going forward? And if they’re not then that whole track record that they earned in the past may be completely meaningless if they’re not going to apply the same discipline going forward. So that’s a very big deal, the inconsistency of these managers.
Number two is something called active share. This is a relatively new statistic. It was actually created by a couple of researchers at the Yale School of Management back in 2006, and what active share attempts to uncover is how a portfolio manager is going to be different or what value are they going to add to the portfolio over and above their benchmark index. And what they attempted to uncover really was are there some basically closet indexers. Portfolio managers that are supposedly actively managing a portfolio but they’re really just doing a lot of things very similarly to the underlying benchmark. And if they’re just going to do things similar to the benchmark, we might as well just buy the benchmark if they’re not going to really add that value. One of the most surprising statistics in this study was that if we look going back to 1980, approximately 1 1/2% of portfolio managers had an active share of less than 60%. Very very low number meaning basically that in 1980 the large majority of these managers were being pretty active with the portfolios that they managed. But by 2003 that number had jumped from 1 1/2% to over 40%, a huge difference there. Meaning that a lot of these portfolio managers are now doing things very similarly to the index. We have to really ask ourself if they’re just doing the same thing as the index what value are they really adding? And that’s going to be something that’s going to have a drag on the portfolio, we believe.
Finally, the third reason are costs. And this is something I’ve talked about on numerous other blogs, but mutual funds tend to be very expensive. In fact, I think they’re one of the most expensive investment vehicles out there. In an article here from Forbes recently titled How Much Do Mutual Funds Really Cost they got into a really nice breakdown on all the different costs that you might be able to expect if you’re buying a mutual fund. There’s disclose cost that mutual funds have and according to a recent study in the Financial Analyst Journal, authored by a couple of professors at University of California, University of Virginia, the average expense ration of a mutual fund is 1.19%. So that really adds up. Then there’s going to be some hidden costs potentially in some of these mutual funds and they talk about that. There may be trading costs that really don’t have to be disclosed but they can really add up nonetheless. And according to that same financial study, they said that trading costs could add up to be another 1.44%. There may be tax costs associated with mutual funds. So when you start looking at these, mutual funds can easily cost 2 1/2%, sometimes even more than 3% per year. And again, if that mutual fund manager is being inconsistent with their approach to managing the portfolio, and they’re not really being very active differently than the underlying index, then why should we be paying these high expenses on these funds? So those are three reasons I think mutual funds are underperforming.
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