Yale’s legendary investment guru, David Swensen, shreds the mutual-fund industry this weekend in the New York Times.
Swensen points out what anyone who has objectively studied the facts of investing inevitably comes to realize: The fund industry costs investors billions in lost returns every year–while coining money for itself, its employees, and its distributors.
The primary promise of the traditional for-profit fund industry–that it’s smart to pay a star fund manager huge money to pick stocks for you–is blown apart by performance data, which shows that the vast majority of funds lag low-cost index funds every year. And the minority of funds that beat index funds this year–about a third in most years–won’t likely beat them next year or the following year.
Meanwhile, urged on by misleading “quality” rankings, investors consistently choose to invest in funds that have done well in the past, not funds that are likely to do well in the future.
Specifically, year in year out, investors buy funds that have been given 4 and 5 stars by Morningstar and withdraw money from funds that have been given 1 and 2 stars. They do this despite the fact that even Morningstar admits that the ratings aren’t predictive–that 4 and 5 star funds aren’t likely to do any better in the future than 1 and 2 star funds.
What is predictive?
The lower the cost of a fund, the more likely it is to do well in the future (relative to other funds). The higher the cost, meanwhile, the less likely the fund is to do well. This is one reason that index funds outperform “actively managed funds” (funds with managers paid to pick good stocks and sell bad ones) year after year: The manager’s salary is deducted from the fund’s returns, and most managers aren’t good enough to offset the cost of their salaries and their employer’s profits.
Why don’t financial advisors tell their clients these simple facts?
Because financial advisors like to believe (or pretend) that they can add more value than that–that their acumen and relationships and experience will allow them to select funds that do “better than average.” (Even though index funds do distinctly better than average.) And also because financial advisors are often incented (paid) to recommend certain funds over other funds–and the commissions on high-cost funds are generally higher than those on low-cost index funds.
These observations aren’t theories, by the way. They’re demonstrable facts. If every American who owns a high-cost actively managed mutual fund sold it and bought a low-cost index fund, the average returns of America’s investors would rise considerably–in part because American investors wouldn’t be paying billions of dollars of fees each year to mutual fund companies to lose money for them.
Note: I realize this sounds harsh and disrespectful to the many great people who work in the for-profit mutual fund industry, some of whom are my friends. It isn’t meant to be disrespectful. Some funds–a very small percentage–do outperform indices over the long haul. Some fund managers do actually have an edge. Unfortunately, the vast majority don’t.
The fact is that the clients of most traditional mutual funds would be considerably better off if the fund employees just shut their firms down, re-allocated their client’s money to low-cost index funds, and found other work to do. Equally unfortunately, however, the other work would likely pay significantly less well than the for-profit mutual-fund industry–which is why so few of the folks in the industry do the work necesssary to understand these realities.