Why the Average Mutual Fund Return Stinks

This is a guest post written by David Lewis

I’m going to go out on a limb and say that managed mutual funds should not be long-term investment vehicles. Very few people are experiencing stellar results. DALBAR Inc. has gone on record to say that the average mutual fund return is less than the index it is made up of.

There is one reason that products are sold in the financial world, and that is to make money. It doesn’t matter what you buy: insurance, annuities, mutual funds, stocks, bonds, ETFs, or anything else. The only question is,

How efficiently can you buy these products?

This question rarely comes up, but it should. Efficiency is a major problem with managed mutual funds. They become less and less efficient as time goes on.

Consider the Employee Retirement Income Security Act (ERISA), which essentially gave birth to a new kind of investor: the uneducated kind. Suddenly, programs like the 401(k) started forcing average folks to become seasoned investors. But, there really aren’t any established in-house education and training programs at your typical factory or retail store that teach employees how to invest, the principles of financial markets, and so on.

This Government created problem also created an artificial market for the financial services industry which needed to hire thousands of individuals to service a new group of employees who needed to become investors.

Suddenly, there were quite a few people who didn’t have a formal financial education who were now “professional financial advisors.” They used to be football coaches, car salesmen, stay at home moms and dads, and insurance agents. However, they had found new careers as financial advisors selling complicated investments to people just like themselves.

Fees, Fees, & More Fees.

I have no problem paying a fee for a service. However, not paying attention to fees can be problematic and cause you to lose a lot of money that you don’t have to lose. Mutual funds are notorious for having this problem.

All of this alleged “education” that has been going on in the financial services industry has led most people (even the “professional financial advisor”) to the erroneous conclusion that investing for the long term in a diversified portfolio of mutual funds is a smart thing to do, nay, the smartest thing to do.

I aim to nip that lie right in the bud, right now. In my opinion, mutual funds, specifically managed mutual funds, are the absolute worst investment an individual can make.

The problem with a mutual fund is the fund fees, and not so much the fees, but the way the fees are charged. Mutual funds are set up to perform worse and worse as the fund grows larger, and the fees are designed to take up more and more of the portfolios earnings the longer an investor holds onto them.

I’ll say this again, the return on investment in a mutual fund is, all other factors being equal, much lower on mutual funds than on many, if not most, other investments and gets lower as time goes on. The main reason most financial advisors recommend that you invest for the long-term in mutual funds is simple. They know that the longer you hold onto the fund, the more money they will make.

Many advisors are discouraged from selling up-front commission products, so they shy away from Class A shares in mutual funds which charge an up-front load. Instead, they appear to be doing the investor a greater service by suggesting Class B Shares. Class B shares offer what’s called a “contingent deferred sales charge”, which acts as sort of surrender charge for selling shares prior to a specified number of years.

This CDSC or Contingent Deferred Sales Charge encourages long-term investment in the fund. However, as you will see, this often results in a severe misallocation of funds on the part of the investor and a huge opportunity cost.

John Bogle, the founder of the Vanguard Group, explains in an interview with Frontline:

“What percentage of my net growth is going to fees in a 401(k) plan?”

Bogle replied,
“Well it’s awesome. Let me give you a little longer-term example. An individual who’s 20-years old today [is] starting to accumulate for retirement…. That person has about 45 years to go before retirement — 20 to 65 — and then, if you believe the actuarial tables, another 20 years to go before death mercifully brings his or her life to a close. So that’s 65 years of investing. If you invest $1,000 at the beginning of that time and earn 8 percent, that $1,000 will grow…to around $140,000.”

“Now the financial system — the mutual-fund system in this case — will take about 2.5 percentage points out of that return, so you’ll have a net return of 5.5 percent, and your $1,000 will grow to approximately $30,000 to you the investor.”

“Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return. And you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return. That’s a financial system that’s failing investors because of those costs of financial advice and brokerage, some hidden, some out in plain sight, that investors face today. So the system has to be fixed.”

To further illustrate this example, let’s use a portfolio of $100,000 (any dollar amount will work the same). If you invested $100,000 in a diversified portfolio of mutual funds and averaged 8% per year, after 30 years you would have $1,006,265.69.

However, this assumes the fund carries no fees. When you consider the fees associated with owning that fund at 2.5% every year, you will find that after all fees are subtracted, you really only made $498,395.13, while the fund made $507,870.56.

Remember, this is an illustration that covers 30 years, a realistic time horizon for most folks. This means that if you start investing for your retirement at age 40, by the time you are 70 (the “prime” of your retirement), you’re likely losing money no matter what your advisor says you’re earning in the form of opportunity cost.

The mutual fund has, at that point, become so inefficient that you might be better off looking at something else.

Stop reading articles, books, and websites that contain a lot of B.S. and “filler information”. If you want hard-hitting, no holds barred information about your mutual fund return problems, visit http://www.twintierfinancial.com right now.

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