When most people read this statement they interpret it to mean that most Mutual Fund returns are below the return of a common benchmark such as the S&P 500 Index. Let’s break this down a bit. First, we need to always keep in mind that we are talking about Total Net Return. This means that we account for price appreciation (positive or negative), dividend payments, fees, and taxes. We can look at these in turn. While we all should have a basic idea about price appreciation, let’s be clear. If you buy something for $100 and can sell it later for $200, you have a basis of $100 and appreciation of $100. Pretty simple.
However, it’s amazing how often people leave dividends out of the discussion. This is often done for self-serving purposes. For example, when people give presentations about variable annuities, they typically leave out the dividend payments and just compare the annuity payment to the level of the index that the annuity is being compared to. This is fair in the sense that the payment is based on that level, but to leave out the dividend payment is to cheat – plain and simple. Statements like, “The Index rose from $100 to $200 in 10 years but the annuity paid out $100 over that time with no variability” sounds cute, but it ignores the fact that the S&P 500 index also paid an average of a 2% yield over that period. 2% times $100 is only $2 per year, but over 10 years this is at least $20. To speak as if the index fund holder didn’t get that money is not quite lying, but it is pretty darn close.
A recent blog (June 2024) from Bob Carey lays out a compelling example of why this common omission is a big deal.
(https://www.ftportfolios.com/Blogs/MarketBlog/2024/4/25/concerned-about-keeping-pace-with-inflation)
In his latest post he considers the time period from 1979 to 2024. This is a 45 year window. Over that time dividends paid from an S&P 500 Index fund rose at a rate of 5.78% per year. In fact, 34% of the total return over that period was in the form of dividends. To ignore this while claiming that you offer a better deal is simply unfair. For the sake of comparison the CPI was roughly 3.13% over that same span. Even if your appreciation didn’t keep up with inflation, the dividend payments certainly did. Of course, that begs the question, “Why did you say that stocks were too risky again?” But that’s a discussion for another time. The point is that just looking at the level of the index is the wrong way to think about it.
Next, we need to look at a running record of how well mutual funds do in comparison to the index taking dividends into account, and adding the effect of fees as well. Fortunately, the SPIVA database was created for exactly this purpose.
https://www.spglobal.com/spdji/en/research-insights/spiva
If we compare large-cap funds to the S&P 500 we see that the funds had a great year in 2023. Roughly 40% of them beat the index – woo hoo!!! Of course, if we extend the view to consider 5, 10, and 20 year periods, this figure drops to 21%, 12.58%, and 12.1%, but let’s not nit-pik. The chief driver of the fact that the funds under-perform is that the fund has to charge fees to do its job, and this money has to come from someplace. It’s hard to beat the average if you have to charge a fee along the way and that reduces the total return.
Consider the example of a 9% return before fees and a net 8% return after fees. With a 9% return your money doubles every 8 years. With an 8% net, your money doubles every 9 years. After 36 years, the fund with the 9% return doubled 4 times while the fund netting 8% doubled 3.5 times. This is a clumsy way of saying that after 36 years one account has about 25% more money in it than the other. A 1% fee for one year is no big deal, but keeping it every year over a career eventually becomes a massive amount.
It may not be clear why taxes become an issue since you eventually pay taxes regardless of how the money is invested, so let’s look a bit more closely. The SPIVA database shows that the share of funds that beat the index after both fees and taxes are accounted for last year was 45%. Considering a 5, 10, and 20 year horizon, those figures drop to 5%, 2% and 3% respectively. One complication of mutual funds is that the fund manager doesn’t time the buying and selling of shares to optimize your tax payments. They can’t, because they don’t know your particular setting. Thus, they buy and sell when they believe that doing so will lead to an increase in portfolio value. The result is that you end up paying the taxes and you have no control over the timing. This is not such a bad deal when the market goes down, because your losses may reduce your tax bill. This is one reason that funds did relatively well in 2022 when the S&P dropped roughly 18%. On the other hand it can hurt you when it rises and you are paying taxes due to sales that you had no control over.
So much for the good news. Let’s talk about the second meaning of the word “Funds”. Here I am not speaking about most mutual funds as an instrument. I am speaking about most of the money deposited into the mutual fund. The problem is that most money flows into a fund only after it shows good performance. This means that if we look at a fund that was highly successful over the past 10 years, it is typical to have most of the money in that fund added only after the best years of performance – not before it. The net result is that most of the money in the fund did not produce the returns reported by the fund to the average investor in the fund.
It works like this. Start with $100 in a fund and beat the market for a few years. After 5 years you may have $200 compared to the $100 that you started with. However, the fund will advertise its great performance to attract new investors. Suppose that $200 is added to the fund at this stage and the total return in the fund is 0% for the next 5 years. Now the fund reports an average return of about 7% per year over the entire 10 year span. However, a total of $300 has been invested ($100 in year 1 and another $200 in year 5). The total fund balance after year 10 is $400. Thus, the average dollar invested has earned only about 3%, and the money added in year 5 has earned nothing. The end result is that the average investor saw returns considerably lower than what was reported by the fund. This is not to say that the fund manager is lying. They are just not reporting the number that really matters to you.
We also have the survivor’s problem. This is the issue that arises when the fund managers close funds that do poorly and merge those funds into the funds that did well. The firm only reports results on the funds that survived the entire period even though several other funds stunk, and the money in them (after the loses were realized) was rolled into the more successful funds. Then the problem we saw in the last paragraph plays out again. The bottle line is that either way, most of the money and investors holding the mutual fund never see the return reported by that fund.
So the bottom line is that most “Mutual” Funds do not keep up with the market, and most of the “Funds” invested in Mutual Funds do much worse than that.
