Why Most Mutual Funds Lag Behind the Market?

According to recent research by Dalbar, the average mutual fund investor has gotten only a 2.6% net annualized rate of return for the 10-year time period ending Dec. 31, 2013. The same average investor got a staggering 2.5% over 20 years, while the 30-year annualized rate is just 1.9%. That is jaw dropping.

In comparison, the S&P500 annualized returns over the same periods were 4.85% over 10 years, 7% over 20 years and 8.3% over 30 years. In fact, 80% of US equity funds underperformed over the last 10 years.

mutual fund returns

What if you find a mutual fund that is in top 20%

A few fund managers who do get better than market returns usually charge a high fees so the additional value is kept by them leaving most investors average or below average returns. In fact, all of the fund managers charge a hefty fees, usually between 1-3% of your assets under management so they get paid their commission whether your investment is up or down. Investing in mutual funds is a great way to take your hard-earned money and pay for fund manager’s retirement rather than your own retirement.

Beware of Load Fees

High fees are not the only downside of mutual funds. Most of the mutual funds have loads. Loads are fees you pay when buying or selling a mutual fund and it is used to pay sales people or other intermediaries for selling you the fund. So lets say you invest $10,000 and bought a mutual fund with a 5% front-end load fees through your broker. Out of your initial investment, $500 goes to the bank and the rest is invested in the mutual fund. So instead of $10,000, you only have $9,500 to invest in mutual fund. You need to get a return of 6% during the first year, just to pay for the fees. It’s called a front-end load because it happens before the money is ever invested. Back-end loads are usually charged if you sell the fund within a specified time frame, usually about 3 to 7 years.

So what should an average investor do?

Don’t panic as there is hope. Since most funds charge huge fees and leave investors underperforming the market indexes, the idea is to not try to beat the market (which mutual funds cannot do anyways) but to look for a fund that at least matches the market return and has minimal fees. This can be achieved by investing in a specific type of mutual fund called index fund.

Why invest in Index Funds?

Instead of being actively managed by an investment professional like most mutual funds, index funds are of passive investment funds that track a market index, for example: the S&P500 or Dow Jones. Since the index fund is tracking an index, there is no need for a manager to pick stocks for you and hence no high active management fees. The also means that you will get same returns as market. If market goes up by 7%, your investment goes up by 7%. If market goes down by 7%, your investment goes down by 7%. But since we know that market over a long-term tends to go higher, so should your investment. Thus by getting market returns and not trying to beat them, you come out ahead of most active managers.

No wonder the billionaire investor Warren Buffet wants his heirs to invest his estate in a simple portfolio of inexpensive index funds. He also suggested that most institutional and individual investors will find the best way to own common stock is through an index fund that charges minimal fees.

Not All Index Funds Are Equal

As I explained above, fees is a killer that will erode your returns. There are some index funds that do have high fees. So do not just invest in a fund because it’s an index fund. Look for a fund that has low expense ratio. Vanguard funds are usually a good place to start. That’s where I have my investment accounts. 

Ready to invest your money in index funds? Head over to Vanguard and open an account. No, I don’t get any commission or make any money when you sign up for Vanguard through my site. 

What kind of investor are you? Do you invest in mutual funds or index funds? What kind of performance vs fees have you seen? Feel free to  share your thoughts.

Leave a Reply

Your email address will not be published.