Three Performance Problems with Most Mutual Funds

For all their virtues, mutual funds have some serious flaws. To their credit, mutual funds can provide things that most investors desire, things like broad diversification, transparent holdings, good liquidity, and easy trading. Unfortunately, most mutual also have serious performance flaws.

They underperform. The most serious and often discussed problem is that most mutual funds underperform. By underperform, we mean that they fail to match the performance of the market benchmark for that asset class. And by most, we mean the overwhelming majority of funds, roughly 80 percent over ten and fifteen-year periods. The semi-annual report known as SPIVA (S&P Indices versus Active) issued by S&P Dow Jones for the past 15 years has placed this assertion beyond dispute.

For example, over the 15-year period ending June 2017, the results for US stock managers were dismal: 93 percent of large-cap managers, 94 percent of mid-cap managers, and 94 percent of small-cap managers failed to outperform their benchmarks. The results for international stock funds were much the same. Across four categories of international stock funds, the percentage of funds underperforming their benchmark ranged from 83 percent to 95 percent. Across 14 categories of fixed income, the percentage of underperforming funds ranged from a low of 71 percent to a high of 98 percent.

To put a positive spin on it, roughly one out of five managers may outperform their benchmark over ten and fifteen year periods. Those are not great odds, but they are not impossible odds either. In theory, out of a universe of 8,000 funds, there are hundreds of possible winners.

In practice, though, it is exceedingly difficult to pick out the winners in advance. One explanation for that is due to the next problem, good performers are not persistent.

They aren’t persistent. The urge to extrapolate past outcomes into the future, especially about past winners, is a difficult bias to overcome. It is very tempting to try and identify future winners by looking at who has performed well in the past, especially in the very recent past.

Looking to past performance does not work, however, because very few top-performing funds are consistent winners. S&P Dow Jones tracks this in their semi-annual Persistence Scorecard. For example, a recent report looked at the top performing U.S. stock funds as of 2013 and then tracked how well they did over succeeding years. Their findings affirm the dictum that past performance is not indicative of future results. Out of the top 25 percent of managers in 2013, no large-cap managers, mid-cap managers or small-cap managers were able to stay in the top 25 percent by 2017.

It is not simply that the top performers slid a bit and dropped into the next tier. The problem is that their subsequent performance is all over the map. Across all U.S. stock categories, of the top 25 percent at the start of the period, fewer than 25 percent even stayed in the top half a mere four years later. That means that most of the funds dropped into the bottom half of performers or, worse, were liquidated or merged with another fund, usually because of performance shortcomings.

We know from the SPIVA performance data discussed above that a minority of funds will turn out to be good performers over the long run. The problem is that the variability and bumpiness of fund performance along the way makes it difficult to stick with them through all their ups and downs.

Not only is it difficult to identify superior fund managers in advance, it is challenging emotionally for investors to stay loyal to a manager whose performance can vary so much from year to year when measured against their peers and their benchmark. The persistence problem, the fact that few funds can consistently perform at top levels, means that it is nearly impossible for an investor to know that he is invested with a winner.

They drift. Style drift refers to the tendency of some managers to drift away from their stated investment strategy or style of investing. Style drift occurs, for example, when a large-cap manager drifts into mid cap or small cap stocks, or when a U.S. stock manager drifts into international stocks, or when a value manager drifts into growth stocks.

Over relatively short periods, style drift may be barely perceptible, but over longer periods it is a problem. Over a single year, more than 90 percent of funds remain true to their stated investment objective. Over fifteen years, however, well over 50 percent of all U.S. stock funds had drifted into another investment style or objective.

Style drift presents two related problems for investors: it changes their asset allocation and it changes their risk exposure. There is a third problem if investors do not realize that drift is happening. Studies indicate that asset allocation – the amount of exposure to different asset classes – is the single most important factor affecting the portfolio performance realized by the investor. An investor may have targeted a set percentage of U.S. versus international stocks, only to find that style drift by one or more managers has resulted in a very different allocation. Fewer stocks, or more international stocks, or more small-cap stocks than planned can all mean different risk exposures and outcomes than an investor had anticipated.

Mutual funds are a perfectly sound investment vehicle. They will probably remain the preferred investment vehicle for most investors for years to come. But investors need to constantly monitor their selections to be sure that they are getting what they paid for.

This article appeared in the February 15th, 2017 issue of The Daily Record. Download a PDF copy.





Have ETFs made mutual funds obsolete?

In recent years, we have heard mutual funds be characterized as outdated and inferior to the newer type of pooled investment known as exchange-traded funds or ETFs. Are they?

ETFs are certainly newer and more innovative. New fund launches in recent years have overwhelmingly been ETFs as opposed to mutual funds. Mutual funds, by comparison, can look stodgy and outdated. Yet, despite being old-school, there are good reasons why mutual funds will continue to be the go-to investment vehicle for most individual investors.

Since the 1980s mutual funds have been the most common way for individual investors to gain exposure to the financial markets. Mutual funds are a type of pooled investment vehicle through which investors can obtain diversified exposure to stocks, bonds or other asset classes. Rather than buying individual stocks or bonds, a single mutual fund share can give an investor exposure to a broadly diversified portfolio.

ETFs are also a pooled investment vehicle. In fact, most ETFs are set up under the same legal structure as mutual funds. They differ from mutual funds, however, in one critical aspect, in how they are traded.

Mutual funds shares are bought and sold directly with a mutual fund company. Mutual fund shares can be held in an account directly with the mutual fund company or they can be held in a brokerage account, but in either case, the underlying transaction is between the investor and the mutual fund company. Mutual fund transactions are processed once a day, after the close of market trading.

ETF transactions are very different. ETF shares trade on an exchange like stocks. An ETF trade occurs between two investors, one wishing to buy and the other wishing to sell. The ETF company is not a party to the transaction. Unlike mutual fund transactions, which are processed once a day, ETF transactions can be processed at any time throughout the day while the market is open. This is known as intra-day trading.

Trading flexibility. The relative ease and flexibility of intra-day trading is touted as a major advantage for ETFs, but in most cases, the ability to trade intra-day is of little consequence to long-term investors. Over a long holding period, it matters very little whether your purchase was executed at 9:05 am or after 4:00 pm.

Moreover, trading ETFs raises complexities that don’t apply to mutual funds. With mutual funds, all transactions are executed at “net asset value” which is determined daily after the market close. The price paid for a mutual fund share always reflects the value of the underlying securities. Not so with ETFs.

ETF shares generally trade at a premium or discount to the net asset value of the underlying securities. If, for example, you buy an ETF at a premium, the amount paid in excess of net asset value is an additional cost. Likewise, if you sell an ETF at a discount, the difference between the discounted price and the net asset value is value lost. Investors trading in ETFs need to take account of the hidden costs associated with premiums and discounts.

Another hidden cost with ETFs is the bid-ask spread. The price at which an investor buys an ETF (the “ask”) is generally higher than the price at which an investor could sell that ETF (the “bid”). ETFs trading at a very narrow bid-ask spread (a penny, for example) is not a problem, but ETFs trading at wide spreads can mean higher costs for investors. To guard against having an ETF trade execute at an unintended price, most such trades should be placed using a limit order, not a market order, but that’s another discussion.

The advantage of intra-day trading is a non-issue for most long-term investors and the flexibility of intra-day trading comes at the price of additional complexities and potentially hidden costs.

Costs. Another claimed advantage is that ETFs are less expensive than mutual funds. That is largely true if comparing ETFs with most actively managed mutual funds. If the choice is between using a mutual fund with an annual expense of 1% or an ETF with an annual expense of .20%, the ETF offers a clear advantage. If, however, the comparison is between an index-tracking mutual fund and an index-tracking ETF, the ETF is not necessarily the lowest cost option. These days, many index-tracking mutual funds compete head-to-head with ETFs on pricing. Many broad market index mutual funds and ETFs are available with annual expense ratios of less than .10%.

Tax efficiency. A third advantage claimed for ETFs is greater tax efficiency. Here, ETFs present a strong case, but one that should not be overstated. ETFs are certainly more tax efficient than most actively managed funds, meaning those funds which engage in individual stock or bond selection. During rising markets, these funds can make capital gains distributions that are taxable to the fund’s shareholders. For example, one US stock fund reportedly made a 60% capital gain distribution to its shareholders in 2017, while the ETF fund tracking the same market segment, small-cap growth stocks, made no capital gains distributions.

A better comparison, though, is between broad market ETFs and broad market index mutual funds. Both are extremely tax efficient. Many ETFs have made no capital gains distributions in many years, if ever, but the same is true of many broad market index mutual funds. Also, remember that tax efficiency is irrelevant in tax-deferred accounts such as retirement account where individual investors tend to hold most of their investments.

For all their merits, ETFs are not necessarily a superior choice over mutual funds. The best case for their use is probably when dealing with taxable brokerage accounts where tax efficiency is a priority. Hypothetically, there are situations where ETFs are the optimal choice over mutual funds, but in practice, many broad market index mutual funds have provided essentially the same tax efficiency.

In tax-deferred retirement accounts, tax efficiency is not a consideration and it may not be worth it to take on the added complications associated with trading ETFs. All other considerations, including cost being equal, conventional mutual funds may be preferable.

Neither mutual funds nor ETFs should be painted with broad brushstrokes as being good or bad. They are simply investment tools to be used intelligently. Still, for all their stodginess, mutual funds will likely remain the primary investment vehicle for most individual investors.

This article appeared in the January 18th, 2018 issue of The Daily Record. Download a PDF copy.





The Power of Markets from the Perspective of a Pencil

In the age of iPhones and other technological marvels, it is easy to overlook the marvels of more mundane products. Such is the case with a simple lead pencil. The story of the pencil is a reminder of the creative possibilities of collective human efforts; it also illustrates an important lesson for investors.

Nearly sixty years ago, an economist published a short essay “I, Pencil,” in which a pencil narrates the story of its creation, describing the wondrous complexity and the intricate cooperative efforts behind the creation of the ordinary pencil. The full essay, “I, Pencil: My Family Tree as Told to Leonard E. Read,” published in 1958, can be found at:

A pencil has not much to it by appearance: some wood, lacquer, printed labeling, graphite lead, a bit of metal, and an eraser. Sounds simple, yet the pencil rightly claims, “Not a single person on the face of the earth knows how to make me.”

The narrative begins by recounting just a few of its “innumerable antecedents.” The story starts with a single tree that needs to be logged. It proceeds to consider all of the equipment used to harvest the wood – the saws, ropes, assorted machinery, and vehicles, all of which also have their own backstory about their fabrication.

Once at a mill, the logs are cut, kiln dried, tinted and waxed in a series of steps that require the skillful application of other materials and tools simply to create “small, pencil-like slats less than one-fourth of an inch in thickness.”

From the mill, loads of small wooden slats are transported to a factory, itself a marvel of accumulated capital. Here the slats are the retooled with cuts and grooves making them ready to receive a sliver of lead. The lead is actually graphite, a material that must be mined, transported, mixed with clay, chemicals and animal fats, baked for hours at a very high-temperature, and then treated further to ensure the strength of the lead and its ability to write smoothly.

Now beginning to look like a pencil, it receives six coats of lacquer to dress it up and is labeled using a heated mixture of carbon black resins. The pencil is topped with a brass piece that itself must be fabricated and affixed to the pencil. The pencil is finished with a rubber eraser that is made by reacting seed oil from the Dutch Indies with sulfur chloride and then adding numerous vulcanizing and accelerating agents. At least, that is how it was done in 1958.

The ordinary pencil is not so simple after all. “I, Pencil, am a complex combination of miracles: a tree, zinc, copper, graphite, and so on. But to these miracles which manifest themselves in Nature an even more extraordinary miracle has been added: the configuration of creative human energies – millions of tiny know-hows configuring naturally and spontaneously in response to human necessity and desire and in the absence of any human master-minding!”

The story of the pencil is about the power of markets to focus the collective creative energies of thousands upon thousands of individual participants and to produce an outcome that no single person could achieve. Each participant contributes “a tiny bit of know-how” and market prices are determined by the combined knowledge of all the participants.

Similarly, the financial markets reflect a collective knowledge that exceeds the knowledge of any single person. The financial markets reflect the collective judgment of its millions of participants, allocating resources and setting prices through their coordinated actions. But no one person knows what the market knows.

Some investment strategies try to outguess the market. Occasionally they work, but most often they do not. Over the long-term, it is very difficult to outperform the market because the market collectively is smarter than any single person. Occasional superstars like Warren Buffet seem to suggest otherwise, but even Buffet has openly acknowledged that for most investors there is little point in trying to fight the market.

If only someone would come up with an investment strategy that, instead of trying to outguess and outperform the market, simply aims to harness the collective wisdom of market prices by capturing broad market returns at a low cost.


This article appeared in the December 21st, 2017 issue of The Daily Record. Download a PDF copy.