Only Fools Fall in ...
Managed Funds?

By JONATHAN CLEMENTS

Santa Claus and the Easter Bunny should take a few pointers from the mutual-fund industry.

All three are trying to pull off elaborate hoaxes. But while Santa and the bunny suffer the derision of eight year olds everywhere, actively-managed stock funds still have an ardent following among otherwise clear-thinking adults.

This continued loyalty amazes me. Reams of statistics prove that most of the fund industry's stock pickers fail to beat the market. For instance, over the 10 years through 2001, U.S. stock funds returned 12.4% a year, vs. 12.9% for the Standard & Poor's 500 stock index.

Moreover, fund performance is even worse than statistics like this suggest. How lousy are the results of actively-managed stock funds? Let us count the ways:

Mercy Killings

Almost all fund statistics suffer from what's called survivorship bias. Fund companies regularly kill off rotten stock funds, typically merging them into other funds with better records. That means these rotten performers disappear from the fund averages, thus making actively-managed funds look like a better bet than they really are.

For proof, consider some numbers from Vanguard Group in Malvern, Pa. Using the Lipper mutual-fund database, Vanguard calculates that U.S. stock funds returned 12.5% a year over the 31 years through year end 2001, compared with 12.3% for the S&P 500.

A clear victory for active management? Not quite. That 12.5% excludes all the funds that were liquidated or merged out of existence over the 31 years. If you add these funds back, you find U.S. stock funds returned 11% annually, or 1.3 percentage points a year less than the S&P 500.

The solution is to ditch actively-managed funds and buy market-tracking index funds instead. True, that means giving up any chance of beating the market. But with a low-cost index fund, you can be sure of garnering the market's result, minus maybe 0.2 percentage point a year because of the index fund's expenses.

Too Taxing

Index funds look even better once you figure in taxes. Index funds don't actively trade their portfolios, so they tend to make relatively modest capital-gains distributions each year.

Meanwhile, many actively-managed funds trade with reckless abandon. As a result, these funds often realize their stock-market profits quickly and thus end up making big annual capital-gains distributions. Shareholders then have to pay taxes on those distributions, leading to lower after tax results.

The brutal impact of taxes was highlighted in a study by Robert Arnott, Andrew Berkin and Jia Ye that appeared in the summer 2000 Journal of Portfolio Management. The authors looked at the performance over the 20 years through year-end 1998 of stock funds with at least $100 million in assets. They adjusted each fund's performance for taxes, including those taxes that would be owed upon selling a fund.

For fans of actively-managed funds, the results aren't encouraging. After all taxes, just 16% of active funds managed to beat Vanguard's S&P 500 index fund. For these funds, the margin of victory was 1.46 percentage points a year. What about the other 84%? They lagged behind Vanguard's S&P 500 by an average margin of 2.67 percentage points a year.

Loaded Down

The case for index funds is also strengthened once you figure in fund-sales commissions. Most index funds don't charge sales commissions, also known as "loads" in mutual-fund lingo.

That's a good thing, because paying a load makes it awfully tough to earn superior returns. If you invest $1,000 in a fund that charges a 5.75% load, your account balance starts out at $942.50. That means you have to earn 6.1%, just to get back to even.

Loads, like taxes, are ignored by most surveys of mutual-fund performance. But if loads were included, the results for actively-managed funds would look even worse.

Risk Unrewarded

Even though actively-managed funds lag behind index funds, that lackluster performance wouldn't seem so surprising if these funds were taking less risk.

But are active funds less risky? It seems plausible. Actively-managed funds typically keep some 5% of their assets in cash, while index funds remain fully invested in stocks.

Yet it turns out that, even with that cash cushion, active funds have performed 16% more erratically over the past decade than a broadly diversified index fund, according to the Bogle Financial Markets Research Center, which is funded by Vanguard.

What explains this greater risk? It seems active funds own stocks that are smaller than those found in index funds, and these smaller stocks tend to be more volatile.

Skewed Results

Check the statistics, and 1999 looks like a big year for actively-managed funds. The funds returned 28.7%, easily outperforming the S&P 500's gain of 21%.

But if many investors in actively managed funds didn't feel like celebrating, there was a good reason for that. Only 48% of U.S. stock funds outpaced the S&P 500 in 1999, according to the Bogle Financial Markets Research Center.

What happened? At issue is the notion of "skewness." A fund's potential gain is unlimited, but it can't lose more than 100% of its value. This phenomenon can distort fund statistics.

If a few funds post huge gains, that will push up the average for all funds, so that a majority of funds end up trailing behind the fund average.

Result: While it looks like active funds posted strong gains, most fund investors would have been better off in market tracking index funds.