Great Mutual Fund Trap An Investment Recovery Plan

Chapter 1 Money Management in a Nutshell Finance, N. The art or science of managing revenues and resources for the best advantage of the manager. --Ambrose Bierce, The Devil's Dictionary An Analogy Every day there is a parade of money managers interviewed on CNBC or featured in Money or similar magazines. Every time we see them, we can't help but think of flipping coins. Imagine that, instead of picking stocks, these scores of men and women each flipped one hundred coins per day, with the goal of producing the maximum number of "heads" possible. Viewers tune in to see who's doing well and bet on their favorite flippers. Over time, the flippers' task is essentially hopeless: statistics doom them to an average performance of 50 percent heads. If you observe them on only one day, though, there will be winners and losers. While most will have around 50 heads, some will have 57 or 43. Now suppose that some of the coin flippers are permitted to raise the stakes of each given flip by taping up to five coins together. For example, if one tapes four coins together, each flip will yield either four heads or four tails. Now, we might expect some of our flippers to produce 60 or 64 (or 40 or 36) heads in one day. By taping the coins, they are taking on risk (the possibility of four tails at once) in return for the possibility of reward (four heads). Imagine, then, the Coin Flipping News Network (CFNN), giving us twenty-four-hour-a-day coverage of the flipping market. In comes coin flipper Lee with 56 heads, touting her latest tactic--say, many revolutions of the coin, with three taped together. Long forgotten is last week's guest, who had favored the few-revolution, one-coin-at-a-time tactic that worked so well during the last 500 flips but is now seriously out of favor. "Momentum" viewers favor those who have recently had more heads, while "value" viewers favor those who have recently had more tails. Above all, viewers are assured that they are not capable of flipping the coins themselves--that they must rely on the experts to do it for them. And they are convinced that they should never be satisfied with just 50 percent heads--that is, "market" performance. The Reality The current state of money management is similar to this example--only worse. The returns for money managers are like those of our coin flippers. Most tend to stay close to the mean, while riskier funds tend to produce more volatile returns that balance out over time. The difference, though, is that whereas coin flipping is free, money management is not. For that reason, the chances of your money manager beating the market are small. Evidence suggests that the average actively managed mutual fund underperforms the market three years out of five. According to data at Morningstar (which maintains a comprehensive database on fund performance): * Through the end of 2001, there were 1,226 actively managed stock funds with a five-year record. Their average annualized performance trailed the S&P 500 Index (a measure of the U.S. stock market) by 1.9 percentage points per year (8.8 percent for the funds, and 10.7 percent for the index).1 There were 623 actively managed stock funds with a ten-year record. Their average annualized performance trailed the S&P 500 by 1.7 percentage points per year (11.2 percent for the funds and 12.9 percent for the index).* * These figures include the sales loads charged by many funds. Loads are akin to brokerage commissions and come straight out of your returns. They are charged by many funds when you either buy or sell shares of the fund. Even with those loads excluded, however, the average five-year return trailed the S&P 500 by 1.4 percentage points per year, and the average ten-year return trailed by 1.4 percentage points per year as well. Looking over a longer period of timGensler, Gary is the author of 'Great Mutual Fund Trap An Investment Recovery Plan' with ISBN 9780767910712 and ISBN 0767910710.