I was chatting with a colleague over lunch and she mentioned that she does most of her investing through mutual funds. I suggested to her that she should closely monitor her holdings and consider replacing the chronic losers with the equivalent index fund.

While there are some excellent fund managers, the vast majority of mutual funds simply under perform the market over the long-term. Such long-term underperformance is lethal to a portfolio’s total return. A portfolio of $10,000 grows to $68,500 over 25 years at an annualized return of 8%. If expenses run at 2% of assets per annum, the portfolio grows to just $43,000 and fees have consumed over a third of the returns. Here are some reasons to avoid actively managed funds:

  1. Underperformance: The vast majority of mutual funds trail their respective indices over the long-term. A study in the US found that 78% of actively managed funds lagged the returns of the Vanguard 500 Index fund by an average of 2.6% per annum.
  2. Fees, fees and more fees: The average Canadian equity mutual fund charges a MER of over 2%. Some funds also charge a front-end load or a back-end load. The MER does not include brokerage commissions, which depends on the turnover of the fund (the number of positions that are changed every year) and further drags down results.
  3. Taxes: The returns advertised in mutual fund brochures and advertisements do not include the effect of taxes. A mutual fund with a high turnover will generate a high level of capital gains distributions that are taxed at the hands of the investor. Losing 20% of annual gains to taxes does not allow compounding to work its magic.
  4. Style and Asset Class Creep: With a lot of mutual funds you are never sure exactly what you own. For instance, during a bear market a mutual fund could hold a significant percentage in cash and still be called an “equity” fund. Many Canadian equity funds hold US and even international equities.
  5. Conflict of Interest: David Swenson writes in Unconventional Success that “the competition between generating management company profits and serving investor interests resulted in a clear victory for the bottom line.” As noted yesterday, it is often better to own the mutual fund company than one of its funds.

This article has 11 comments

  1. It should be noted that 1. and 2. above are essentially the same, especially with the numbers you have given. 1. says that 78% of funds have lagged the index by 2.6%. 2. says that the average Cdn. fund charges an MER of over 2%.

    So saying both 1. and 2. is a bit redundant. You can’t really blame them for both at the same time.

    My thinking is basically that mutual funds should never be used for large cap, but mid-small, maybe. I think that’s where many people make the mistake of buying a large cap mutual fund… I have done that before, when I owned TD Canadian Equity and TD Blue Chip, and more… Should have just owned the TSX Composite or TSX 60.

    5. is a great point! something that has always bothered me.

  2. Canadian Capitalist

    Dave: Its true that point #2 is one of the reasons for point #1. I split them because #2 is known a priori but #1 will be known only in hindsight.

    I think there are a few fund managers who are worth investing with. The vast majority of funds are just not worth owning.

    Personally, except for a venture capital fund that I am locked in, most of my holdings are in index funds, ETFs, dividend equities and value stocks.

  3. “A study in the US found that 78% of actively managed funds lagged the returns of the Vanguard 500 Index fund by an average of 2.6% per annum.”

    This is actually very misleading. Most of these studies classified “actively managed funds” very loosely. About 3/4 of “actively managed funds” are really closet index funds. It doesn’t prove that passive beats active. All they tell you is that closet index funds with high MERs can’t beat index funds with low MERs over the long term. Duh!! Avoiding closet index funds is a given. I just find that all these active vs passive studies/statistics don’t add any insights. You did qualify that some funds are worth investing.

  4. Silverm, that is kind of what am I getting at when I say that 1. and 2. are both the same thing…when you realize that many of the equity funds out there are closet index funds. And also what I mean is that, as you say, it doesn’t really prove that passive beats active, it just proves that 0.5% MER beats 2.5% MER, with roughly the same underlying return.

  5. Canadian Capitalist

    Silverm: The study I am quoting is by Rob Arnott and others referenced from Unconventional Success. I am not saying passive always beats active (I have huge respect for some money managers like Bill Miller, David Dremen, Irwin Michael etc. An investor in these funds would do well to stick with them even if they lag the benchmark for a few years); just that the vast majority of active funds fail to beat the passive index and thus are not deserving of their high fees.

    Whether an actively managed fund is really a closet index fund is immaterial because I’ve never seen a prospectus or ad that says “If you dig deeper , our fund actually tracks the index and hmmm… we charge 2.5%”. Most mutual fund investors cannot tell if their holding is really an index hugger.

    Dave, fees are only one of the reasons for underperformace. David Swensen says in Unconventional Success that other reasons include “poor security selection”, “costs associated with mindless trading” etc.

  6. Great post. You are right on the money about asset creep – this can be a big problem, but sometimes holding cash means that you can outperform the market, expecially as short term interest rates rise. And it means you have money available to take advantage of special buying opportunities.

    I have some questions about points 1-3.

    Shouldn’t the objective be to find the few well managed actively managed funds (that do beat the indexes)?

    If you want to invest in a class of stocks that aren’t in an index (microcaps, for example) what do you do? a total market index will overweight you large caps (especially if you already have an S&P fund).

    If you hold your funds in a tax advantaged vehicle, like a 401(k), IRA or annuity in the US, or an RRSP in Canada, which is where most people hold them, what difference does it make how tax efficient a fund is?

    Finally, why not simply focus on a few good stocks rather than owning lots of average ones?

  7. Canadian Capitalist

    Doug: I think you should read Unconventional Success.

    The trick is finding a well managed mutual fund before it produces excellent results. Most investors tend to just buy a four or five star mutual fund.

    I am not sure that microcap stocks are a core asset class.

    Actually, 67% of assets were held in taxable accounts in 2002 in the US.

    I know from personal experience that beating the markets is very hard. Most investors do not have the time to research stocks to invest in.

  8. Thanks for the book recommendation – I checked it out on Amazon and it looks very promising.

    Seems like most of the issues have the same root: people looking for shortcuts in investing decisions, rather than doing the hard work of the research to identify a good manager or a good stock other people have missed.

    I realize that many people may lack the knowledge to do the research, but that’s why they should all read this site.

  9. doug said: “Shouldn’t the objective be to find the few well managed actively managed funds (that do beat the indexes)?”

    Sure we can find out which ones have done well in the past but which ones will do well in the future?

  10. I think you’ve all made good points and counterpoints. Why buy a managed mutual fund when most managers can’t beat the index? That’s not even accounting for the higher MERs as compared to ETFs and open ended index funds.

    I have been a long term believer in your philosophy of buying the bank instead of putting your money into a bank account. For me, that saying pretty much applies to all financial services. Commercial & retail banks, mortgage lenders, insurance companies, mutual fund companies and investment banks have all made out better than their clients. In the back of my mind, holding onto their shares makes using their services less painful, as my service charges have been contributing mightily to my investment returns of late!

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