Why So Many Mutual Funds Can’t Beat the Indexes

Mutual Funds

Investing in stock indexes doesn’t require any skill in stock picking at all. How can no skill beat the presumed skill of fund managers? They obviously aren’t using much skill.

Actively managed mutual funds have quite a few limitations versus what we can do with our own accounts as individual investors. If we are considering investing in an active fund, it’s always important to look at what other approaches we could take instead, and how active mutual fund investing stacks up to these other approaches, so we will at least be in a better position to decide.

Whether or not our fund is passive or active, the great majority of individual investors are certainly passive, and strongly prefer remaining so. The less they have to think about their investments the better, and they certainly don’t want to be tinkering with their portfolios.

Those who become disenchanted with 4 out of 5 funds not beating the S&P 500 take the attitude that if you can’t beat them, join them, and index funds which do exactly that have exploded in popularity over the last few years. Thoughts of building and managing their own portfolios, if they had any real inclination, has been scared out of them by an industry who would much prefer that investor funds be under their management.

While it is preferable for investors to go with the odds and choose to invest in an index fund over an active fund, given that the odds are against them with active funds, this doesn’t end the discussion, as there is always the possibility of our being able to do a better job of this ourselves. There are a few things that we will need to learn, but this is nowhere near as difficult or intimidating as just about all investors believe it is.

If we had a situation where these professionals were doing so well that we probably would be better off just letting them do the stock picking for us, where they were crushing the market averages or at least beating them by a meaningful amount overall, it would be reasonable for a lot of people to just let them handle it.

Given how poorly these funds do, with even the ones that eke out a little gain over the market not being able to do this very consistently, this approach simply has us choosing lesser returns, in a way that those even minimally enlightened will see the error of this strategy.

This should not even be a matter of debate, and this is much like rooting for a losing sports team that just keeps telling you that they will get them next year but never do. We’re supposed to be making good decisions here, especially given that we stake so much on our investment returns, but when a plan fails to deliver, we just have to turn our heads away and look elsewhere.

This leaves index funds and self-directed portfolios, and if we decide to choose index funds, we do not have to learn anything about stock picking and portfolio management, at least if we confine ourselves to this plan. Once we get off that track, now we’re off on our own to some degree and if we are willing to do that, we should at least be willing to consider doing more.

A lot of people do meddle with their portfolios as it turns out, mostly by mixing in other asset classes like bonds, and may even go with a mix of index and active funds. Mixing in bond funds is extremely popular, and is the norm these days, and investors will also add in other funds besides those which tracks a major stock index, such as sector funds, value funds, smaller cap funds, emerging market funds, dividend funds, and an assortment of other things.

This takes us far beyond just a passive approach to investing, as these investors are very much engaged in the management of their portfolios, they are just doing it in a way that does not seem to be that transparent to them. These decisions have major implications to where they may end up at the end of the road, and therefore need to be made very carefully.

We’re going to leave aside the issue of asset mixing here, which we talk about plenty elsewhere, and just focus on stocks in this article, where a certain percentage of one’s portfolio will be earmarked for stocks and we then need to decide which stocks to go with. That’s a big enough topic to be sure, and one that investors could benefit a great deal by becoming more familiar with and better situated to decide, especially since they are already making some pretty big decisions already.

If we are looking to improve our understanding of stock selection, perhaps the best place to start is to look at how active mutual funds fall on their faces so badly, to not only try to avoid making the same mistakes, but more importantly, to learn more about the right way by looking at the wrong way and doing something different and something with more potential.

Active mutual funds fail for two important reasons, with the first one being that their slippage is so much larger than ours due to the size that they need to trade. The second major reason is that they just aren’t very good at what they do, and this is the more important of the two because if you pick bad stocks over good ones, the differences in return can be much greater than this extra slippage, involving both a loss of return from the slippage itself and their needing to take on additional risk by needing to swim against the tide so much in order to minimize this slippage.

This is still a big deal and something that should in itself scare us away from these funds, at least if we understand its impact. Funds cannot just enter and exit positions like we can, because the slippage involved would be pretty big. Imagine yourself standing alongside a fund with your relatively small positions which can be executed at the market with ease, versus a fund that may have positions involving many millions of dollars.

We buy at the market price, while they can only buy a very small portion of what they need right now, otherwise they would drive the price up too much and then see it return once they are finished. They have to instead buy the dips, but buying the dips is riskier as the dip might keep going and then you’re stuck entering a position which isn’t so great looking anymore, and they may even be entering when it is instead time to get out.

The same thing happens when they sell, where they need to sell into strength and hope that enough comes their way to get out at a half decent price. This makes entering and exiting pretty maddening, considerably less efficient, and notably risker than what we do.

This is all a given with active funds, and even passive funds suffer from this problem to some degree, although to a much lesser one because their volume is limited to additions or redemptions and does not involve full-scale entries and exits like active funds need to engage in when they switch horses.

The goal for them needs to be to hold superior positions that will provide enough of an advantage to not only overcome the problem of slippage, but to also provide us with enough of a better return to justify the extra risk and even investing in these funds in the first place.

People who know a fair bit about how funds work will point to this slippage as the real problem, although it turns out that few people even understand this, and are just left to scratch their heads and turn away. Picking stocks is tough, they will think, and then decide to have none of this and go with an index.

We at least need to realize that if we were doing this ourselves, we would not have to worry about slippage very much unless we had a huge portfolio, and still would not need to worry about it as much as active funds do unless we are also playing with billions of dollars.

Good Stock Picks Would Make This Worth It, If Only They Picked Good Ones

That’s not the biggest problem though, as if they really were picking good stocks, they should be able to well compensate for slippage and come away ahead overall. All we have to do is look at how good stocks do versus bad stocks to show this, and this isn’t even a matter of finding real good ones, as just avoiding the bad ones is plenty enough.

All we need to do to confirm this in the real world is to look at what stocks these funds like, and it turns out that they like plenty of ugly ones. Ugly might be considered beautiful in some cases by some people, but it never is with stocks.

The S&P 500 has 500 different stocks in it, some better than others to be sure. Why we would ever want to own them all without even looking in this bag of groceries? We are going to need to have some sense of what is a good and bad stock of course, and although that is a skill that appears to be in short supply overall, this doesn’t mean that this needs to be difficult.

All we need to do in fact to become reasonably skilled at this is to understand that the metric that active funds use needs to be our goal as well, although we may wonder if it is all that prominent of a goal for these funds.

They may tell us that they want to beat the indexes, but you would never know it by how many below average performers that they hold. Below average quality stocks lead to below average performance, unless you get lucky, and we cannot depend on luck to help us with inferior odds, because we’re now up against probability, which has us unlucky on balance.

Stock selection should never be a difficult task, provided that we understand that the goal here is to select the good over the less good. The biggest thing that we need to reform is the way many of us love to root for underdogs, and while that may please us when we don’t have a financial stake in the matter, betting money on underdogs with their inferior odds should not be something that we ever do.

This one thing explains the failure of the majority of actively managed mutual funds more than anything, because this is exactly what so many funds do. This is especially true with funds that specialize in a certain category which in of itself lags the market, where they accept defeat even before the game begins.

We can look at the 3-year returns of various types of stocks to show some of this, although within each category there also can be a lot of weeding that can be done to improve our lot, much like weeding the S&P 500 can help us. However, there are some types of stocks that just don’t do so well, and we certainly do not want to be confining ourselves to picking among an inferior basket.

The S&P 500 doesn’t represent the stock market, it represents 500 large cap stocks. The stock market is more than just large cap stocks, as we also have medium cap and small cap ones that make it up.

2019 was a good year for comparing returns, as far as understanding what is hot these days and what is not, and going with what is hot over what is not is very important because more recent data is more reliable. We want to look a little further out than this though, and the last 3 years serves this task well while still keeping things fresh enough.

The Dow Jones U.S. Total Stock Market Index is the real reference here if we want to look at the market itself, and this is where the continental divide is located, where everything above this line is above average and everything below definitely is not something that we should ever want to be in.

This index is weighted more toward large caps, since that’s where most of the money in the stock market is, and therefore all we need to do in order to show that large caps are preferable is to compare their returns with the big index. Anything over this line is promising, where we then would compare the amount it beat this index by with other options, but we need to be above this in all cases.

This applies to not only categories of stocks, but individual stocks as well. This is where we really go off the road by not getting this, as we may be diligent in comparing baskets of stocks by return, but we forget this even matters when it comes to individual stocks, forgetting that we even need to weed at all and even thinking less of types that are full of weeds but at the same time being happy to buy the weeds one at a time.

Looking at the Performance of Stock Categories Can Be Pretty Insightful

We need to start with the bigger picture though and look at the relative performance of the various major stock categories that we use. Large cap stocks beat the big index over this time by 13.24% to 12.53%, so large caps get an immediate thumbs up.

That’s not enough though, as we want to break all these categories down to growth and value. Growth funds like stocks that are more likely to outperform, while value funds prefer stocks that are underperforming with the hope that this will change somehow. They don’t even need a good reason to believe this and simply like underperformers for its own sake.

Large cap growth stocks beat large cap value stocks by 19.40% to 7.32%, so this was no contest. 19.40% is also well above the average of 12.53%, but 7.32% is well below it and represents the shabby side of big caps.

Medium cap stocks in general have earned 9.24% over the last 3 years, which is also below the line, but not as much as the 5.01% that mid cap value stocks are. Mid cap growth stocks have at least been more respectable with their 12.11%, but that’s still a little below average.

Big is better, and this really stands out when we look at small caps, which only have returned 6.46%. The fact that there is an even smaller category called microcaps, and that category only returned 5.04%, cements this idea further.

With the small caps, once again growth trounces value, with small cap growth stocks returning 9.84%. Small cap value stocks actually had a negative return of 0.13% over the last 3 years, which is simply terrible. When you give up almost 20% per year over 3 years versus large cap growth, this adds up to almost 60%, which you can either be proud of or ashamed of depending on what side of this you were on.

We need to wonder why funds would not all at least go with big cap growth stocks of some combination, or if they wanted to dip into the smaller baskets, they at least need to make sure that the ones they choose can at least earn their keep. The fact that there are so many funds that confine themselves to one of these lesser baskets speaks loudly for the level of confusion in mutual fund land.

It is one thing to try to pick good stocks and fail, but when the task is to pick lesser ones, by design, limiting yourself to categories that don’t perform as well, you have two strikes against you before you even step up to the plate. The level of challenge involved in beating large caps with medium or small caps is very substantial, and all the more so with trying to beat a growth fund with value stocks.

The old-timers may reminisce about the glory days when value stocks actually did pretty well, and lots of them eagerly await the second coming, but times have really changed. This is not only far from the case now, we may never see such a thing again, due to how stock markets have evolved away from this idea and embraced the power of momentum.

When the market is hugging one person and giving a look of disdain to the other, and we want to be on the side of the market, choosing the right one should not be any sort of challenge.

While value funds are married to this idea, a lot of mutual funds of other types have this idea that we will somehow be transported back to the old days, and prevent them from deciding what to hold based upon performance, instead preferring to pretend that we are in bygone days to the extent that even the reality of their failures are ignored.

Putting together our own basket of stocks and doing a good job at it just requires us to understand that if we want better performance, we need to seek it. Making this your goal will in itself put you head and shoulders above the great majority of mutual funds, including the index funds, which aren’t managing for performance at all.

The active ones do manage performance, but don’t manage it very well, which is why they lose to doing absolutely nothing. We don’t have to go into this matter further, as their results itself tell us that they are bad at picking stocks, worse than random.

Picking good stocks also means maintaining good stocks in your basket, which does not mean that we should just be buying then and holding them when they start to rot. The time a stock falls out of the good category is the time that it should fall out of our basket, like throwing away stale food in our refrigerator, to be replaced with something better, as it would be sensible to do.

We can already trade circles around big funds, and with commission-free trading now here, we no longer have to worry about trading small sizes, where the commission on the trade would require a decent-sized move to even get out of the red. This one thing should be empowering a lot more people to build their own portfolios, even though few appreciate their new power.

Given that the big appeal of mutual funds was that we couldn’t put together a diversified portfolio ourselves due to the big commissions we would pay, with this gone, the last valid benefit with mutual funds has left right along with this.

If we just add an approach to picking stocks that actually has the market speaking to us and telling us what it likes, and then go with what it likes, that alone should propel us from the mediocre results that we have grown accustomed to in our quest to beat the market, to one that clearly outshines the market itself and puts a bigger smile on our faces. We won’t have big smiles without trying though.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.