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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:
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 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.
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.
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.
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.
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.
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.
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