8 Reasons Why the Average Mutual Fund Return Stinks

Mutual fund returns have been dismal in recentexcessive capital gains tax compared to other
years...but it's not just a recent phenomenon. Theinvestments. There is significant research that
average mutual fund return has failed - over thesuggests that many investors sell when the
long-term - to beat its underlying index (which youmarket is down or try to time the market, but
can invest in passively relatively cheap).fail miserably (Dalbar, Inc.'s Quantitative Analysis
In this article, I'll be talking mainly about managedof Investor Behavior was first issued in 1995. The
mutual funds. A mutual fund was originally amost recent update continues to show that
financial tool used (and made available for) smallindividual investors are not realizing anywhere near
investors. The mutual fund was a way for themarket rates of return in stocks and bonds
average middle-class American to pool his moneybecause of frequent switching among "hot" mutual
with other like-minded individuals and invest in afunds and trying to time the market. Over a
group of stocks (or bonds) and share in the gainperiod when the S&P grew by 12.98%, the
or loss of the fund. For years, mutual funds haveaverage investor earned only 3.51%. Source:
been seen as the panacea for all of the world'sDALBARinc.com). When investors sell in a down
retirement ills. Over the years, the mutual fundmarket, and the fund manager has to liquidate
industry has changed to accommodate not onlystock at low prices to meet redemption requests,
small time investors, but large ones as well. Withthe remaining investors in the fund also lose
the many changes; however, came many newmoney because of the added capital gains tax
problems. Some of these problems include:that is assessed at the end of the year due to
the excessive liquidation of the mutual fund's
1. The nature of a mutual fund places fundportfolio. Even if the fund doesn't need cash,
managers in total control of the fund's tradingexcessive trading in an attempt to chase higher
methods and investment objectives, not you. So,returns (to attract more investors) can have the
right off the bat, you have lost complete controlsame effect. In essence, it can create a situation
over what you would like to invest in. Remember,where it is possible to lose money over the
the fund is just a "shell" for other financialcourse of a year, and still owe capital gains tax
instruments. All it does is give easy accessbecause of the amount of trading that was going
(perhaps too easy) to the small investor whoon inside the fund.
may not have much money to invest. If you buy6. Excessive transaction costs. Investors have,
into what are called "class A" shares (paying atraditionally, continued to chase the highest returns
commission up front to own the shares), youin the market. To this end, funds have gotten the
may be disappointed if the fund manager decidesidea that they must stay "active" to keep the
to switch investment objectives or trading stylesattraction of new investors and to try to "create"
that you don't agree with. If you choose "class B"those high returns that investors want. This
or "class C" shares (paying a commission whenrequires, in many instances, a lot of trading. But
you sell the fund), you have to either "grin andtrading is not free. Just as if you were to buy
bear it" or cash out, paying the contingentindividual stocks yourself, there is a cost
deferred sales charge associated with both ofassociated with doing trades, even for fund
these classes.managers. This fee, of course will be passed on
2. There are restrictions on your investment. Byto you for your participation in the fund in the
law, most stock positions in mutual funds cannotform of a transaction cost. Although many (if not
represent more than 5% of the fund.most) funds - at this time - do not keep track of
Government regulations have forced this issue fora stock's bid/ask price at the time of a trade, it is
over 60 years through various requirements andestimated to be about .7% (RE: John Bogle;
the result is that this 5% rule, allegedly designedFounder of the Vanguard Group).
to make mutual funds a diversified investment7. Fund fees hurt performance. Lipper Analytical
product, are actually diluting the performance asServices reports that half of all mutual funds
the 5% rule will only effect the best stocks in thecharge their investors at least 1.4% of the
portfolio. This is because the stocks that performinvestor's assets. So if you have $100,000 in
the best will grow to more than 5% of the totalassets with a particular fund that does this, the
portfolio value and must be sold. Meanwhile, thefee for being in the fund would be $1,400 a year.
poor performers will continue to lose money. AsObviously this can add up over the years and
the good stocks grow "too large" and are solddetract from your overall returns.
off, poorer performing stocks are brought in to8. 12b-1 fees. A 12b-1 fee is a fee that is
replace them. This dilutes even the moderatelysanctioned by the Securities and Exchange
good stock's performance. What you are left withCommission (SEC) and adopted by many funds.
is a diversified portfolio; a diversified portfolio ofThe SEC, whose purpose is supposed to be to
poor performing stocks with a small amount ofprotect the investor, has sanctioned this fee for
successful stock mixed into the fund.mutual fund companies to offset the costs
3. There is a special type of liquidity issue withassociated with advertising and other expenses of
mutual funds. Typically, a certain amount ofthe fund. The fee, which can range from
investors' dollars are not invested in the underlying.25%-1% was supposed to help investors by
investments of the fund but are instead set asidelowering the costs associated with operating the
for investors who want to pull out of the fund. Byfund and result in a lower expense ratio as more
its very design, a mutual fund must do this soand more investors bought into it. It is interesting
that it can maintain liquidity when investors wantto note; however, that this fee can be used to
to sell. After all, what good is it to own ansimply increase the cost of doing business. For
investment if you can't sell it when itsexample at one time, the Putnam New
performance has "topped out"? To cloud theOpportunities fund was charging a .25% 12b-1
issue, sometimes it's not exactly clear how muchmarketing fee for a fund that had been closed to
of your money is actually being put to work innew investors for over a year. The investors in
the market and how much is held back forthat particular fund were paying Putnam on the
redemption requests (redemption is just a fancyorder of $20 million a year to sell that fund to
word for selling your fund shares).nobody.
4. Even if a significant amount of money is held inIt is interesting to note that, in addition to the
cash for redemption requests, there must bevarious issues listed above, according to a recent
enough money invested in stocks, bonds, and5 year survey by Lipper, 94% of mutual funds
other financial instruments to keep investorsunder-perform the stock market as a whole. It
interested in investing in the mutual fund. Thiswould appear that even if you can dismiss all of
leads to a situation where when it is time to sellthe other troubles that plague a mutual fund, the
off your investment, there may not be enoughperformance issue would appear to be the most
cash reserves to meet redemption requests.disconcerting for the average investor.
When those cash on hand reserves are notTo combat the challenges and problems facing the
enough to meet redemption requests the fundmutual fund industry, an alternative to the
managers are forced to liquidate stock from themanaged mutual fund was created - a special kind
portfolio. This, in turn, can have a negative impactof fund called an "Index Fund". Index funds are
on the entire fund and hurt your returns if themutual funds that just track the performance of
fund manager has to sell those shares at lowthe stock market as a whole. They don't do very
prices to create liquidity.much trading throughout the year compared to
5. The possibility (and high probability) ofan actively managed fund.