One of the first heuristics taught in any course on personal finance is the Rule of 72. This is the observation that if we want to figure out how many periods it takes to double a value through compounding we simply divide 72 by the growth rate. For example, if we earn 8% per year, our money will double after about 72/8 = 9 years. This is good to know because the average return of the S&P 500 so far this century is roughly 8%.
Meanwhile, the annual cost of owning a mutual fund over that same period was roughly 2%. This includes loads, management fees, reinvestment fees, exchange fees, and other miscellaneous fees. If 2% is taken out of an account that earned 8%, we are left with a return of 6%. At this rate, our initial investment will double in value after about 72/6 = 12 years. This may seem like no big deal, but consider a working life from the ages of 24 to 60. This will be about 36 years. If our money doubles in value every 12 years, a dollar at time 0 will double after years 12, 24, and 36. Our single dollar becomes 2 dollars at year 12, 4 dollars at year 24, and 8 dollars at year 36. Not bad at all.
However, if our investment doubled every 9 years, then at years 9, 18, 27, and 36 we would have 2, then 4, then 8, then 16 dollars. In other words, we can have twice as much money after 36 years if we simply avoid that 2% fee. Of course, the fees are tolerable if the fund manager consistently “beats the market” by at least 2%. Claiming such a level of performance turns out to be pretty easy to do. (Notice that I said “claiming” not “doing”.) Let me explain by using a completely fictitious tale.
Let’s consider a cynical fund manager named Simple Math Jones. Jones begins with 32 mutual funds, each made up of 100 randomly selected stocks. For the sake of this illustration, let’s say that each stock costs $100 and each fund has 1,000 owners. Thus, each fund is worth about 100 * $100 * 1000 = $10,000,000 at time 0, and each of our 32,000 investors has $10,000 in holdings.
After year 1 roughly half of these funds will beat the market and half of them will not because I created them via random selection. Jones then folds the half that “under-performed” into the half that beat. He now has 16 mutual funds that beat the market and the average balance in each fund is around $20,000,000. The 16,000 fund holders who lost money during year 1 will be more than happy to see their money moved into this “superior” fund at the start of year 2, so they are likely to stay the course. We shouldn’t blame Jones for doing this because if he didn’t do this, many of these investors would leave.
After another year, Jones folds the 8 that under-performed into the 8 that beat the market. At the end of the next year, he folds the 4 that lost, into the 4 that won. The next year he folds the 2 that lost into the 2 that won, and after 1 more year, he folds the one that lost into the 1 that won. We now have a mutual fund that beat the market 5 years in a row, that is worth around $32 million, which is the same amount of money that we started with. (I am ignoring the fees that Jones took along the way.)
The firm that Jones works for then aggressively advertises this fund to the public and waits for a rating group like Morningstar to evaluate this excellent performance. Morningstar explicitly states that its rating approach is based on “a purely quantitative, backing looking measure” (See Morningstar Ratings.) There is nothing wrong with that, since it cannot be a forward looking rating without inviting law suits when markets go down. In the interest of fairness, let me add that Morningstar explicitly states that, “Given that the star rating is based entirely on past performance it is not meant to be predictive.” Since my fictional fund has beaten the market 5 years in a row it is quite likely to be in the top 10% of all funds, thus earning the 5-star rating.
Last year, roughly 90% of the new money that went into mutual funds went into top rated funds. Why – because this is what your money manager is going to recommend. On the other hand, if you shop for funds yourself, this is also the set of funds you are most likely to pick from. Notice that in my little example, there is roughly $32 million dollars in the fund when it becomes a top rated fund. Of that amount, only $1,000,000 of those dollars were there at day 1. The other 31/32 or (97%) of the fund holders didn’t beat market for 5 years in a row because they came from a fund that under-performed at least one of those years. Only 3% of the people invested in the fund at this point actually earned the return reported by the fund over its 5 year history.
Now that we have this superstar fund, the real money is going to roll in. That $32 million in year 5 can easily attract 10 times that much in new deposits in year 6, pushing the fund balance to $320 million. If Jones gets lucky and beats the market again (which should happen about ½ the time since the stocks are randomly selected) he can easily increase that amount by a factor of 10 again, pushing the fund balance over $3.2 Billion. Now we have billions of dollars in a fund that beat the market 6 years in a row. Simple Jones starts making appearances on CNBC, Bloomberg TV and so on. He is on the cover of Fobes magazine, Money magazine, etc. I guarantee that, at this point Jones is going to look to increase the fee and his compensation. The firm will go along with it because, if they don’t he can go someplace else and start his own fund and charge a 5% fee for anyone to join – wouldn’t you?
I freely admit that my little story is an work of pure fiction and not an indictment of any fund manager. However, the sad part is that my tale is not as far-fetched as it may sound. Twice per year S&P Global publishes its “S&P Indices vs Active” report (SPIVA) which compares mutual fund returns to those of a simple index. The latest report indicates that 39.1% of actively managed funds outperformed the S&P 500 index over the past year, meaning that over 60% did not. (Remember, if you simply pick stocks randomly you will beat the index about 50% of the time.) If we consider the past 3, and 5 year periods those values fall to 20.2%, and 13.4%. You may be thinking, 13.4% beating the market after 5 years is not so bad, but remember, that figure only includes funds that stayed around for at least 5 years. It doesn’t reflect the funds that disappeared over that period. In other words, that value is being derived from a biased sample. Many of the funds that started 5 years ago no longer exist. My little story is an unfair exaggeration, but its not off by as much as you may think.
You can certainly argue that for retirement planning 5 years is too short a time period, and that the S&P 500 index is not the best index to compare each fund to, because some funds inherently have more risk than others. Fortunately, the data is informative here as well. If we look at Large-Cap, Mid-Cap, and Small-Cap funds and compare them to the S&P 500, the S&P Midcap 400, and the S&P Small-Cap 600 over a 20 year period, the proportion of mutual funds that under-perform are 85.6%, 75.5%, and 86.0% respectively. Apparently, digging deeper into the numbers simply makes the gap larger. Let me repeat that relatively few of the investors in the top performing funds saw the returns of those funds over this period because most of the money moved into those funds after they performed well.
While we are adding realism to the discussion, did I mention that 40% of all mutual funds over this period have a Load up front? In this context a Load is a pay a fee paid just to get your money into the fund in the first place. These fees range from 2 to 5% of the initial deposit and stand in addition to any annual fees that follow. So beating the market on an annual basis doesn’t justify the expense until the amount by which you beat it exceeds the up front fee in addition to the annual fee. One more thing, did I mention that if any trading goes on within the fund that beat that market, you pay capital gains taxes on any sales of securities if a profit was made. Typical mutual funds turn over roughly 75% of the fund holdings each year. Between loads, fees, and taxes, the typical fund manager has to beat the market by more than 3% per year for you to do as well as you would have done with a simple index fund.
One last thing. As I have said on this blog on several occasions. If Simple Jones could consistently beat the market by 3% per year, he could easily use options and leverage to magnify that difference by a factor of 10 or even 100 for himself. If anyone knew how to do that, why the hell will they sell that skill to you for a 2% fee? Simple answer – they won’t!!!
