Mutual Funds: Do They Out-Perform the Markets?

Mutual funds are thought to give you a better chance at beating the markets.  It this true?  It’s an important question if you want to know whether the fees paid on mutual funds are worth the cost.  They can certainly add up over time.  For the purposes of this article, we’ll take mutual funds to mean a managed fund that uses collective investment money to purchase primarily stocks, bonds, other mutual funds and money market investment vehicles…the kind most of us saving for our retirement are exposed to.

Mutual funds and other actively managed funds are frequently recommended by investment and financial advisors.  They are packaged nicely and advertised aggressively… and come along with lots of fees and transaction costs.  Big money managers are hired and paid millions of dollars to make sure mutual funds perform.  Fees are necessary to pay for expensive fund managers. The financial advisers who recommend the funds have to be compensated as well.

All of this makes for a costly investment product…but the added expense is worth it because you get our money back and more due to increased returns on our investment when you use mutual funds, right?

Mutual Funds Investigated

Unfortunately, studies regarding mutual funds show otherwise.  Michael Edesess, a PhD mathematician and economist, has studied this question in detail.  His research (along with several other studies cited in his book, The Big Investment Lie) shows some interesting results when it comes to mutual funds and other  managed funds.

When mutual funds are studied in any scientific manner, the research always comes up with some variation of these two findings:

  1. The average returns on mutual funds DO NOT outperform the markets.
  2. There is no way to predict which mutual funds will outperform the markets in any given year.

So what does that mean?

Picking winning mutual funds?

While some mutual funds (about half) outperform the markets each year…and the other half of mutual funds don’t.  A lot of them cluster around the same returns as the market averages.  The evidence also shows that choosing  mutual funds that will beat the markets any given year is pretty much impossible.  Some people will get lucky and buy mutual funds that do well for them, but according to the numbers and studies to date, these cases are more about luck than good management.

“But what if you pick mutual funds based on past performance…they can predictably beat the market, can’t they? ”

If you select a mutual funds manager whose results have been better than the markets for the past five years in a row, what are his chances of repeating the same thing this year?  You’d think they would be at least better than average…but actually it’s a 50-50 chance.

Of the mutual funds managers that under-performed for five years in a row…they have the same 50% chance of beating the markets this year.  Past performance makes no difference.

  • You have a 50-50 chance of picking the right mutual funds.
  • Your advisor has a 50-50 chance of picking  winning mutual funds for you.
  • Chances are, the mutual funds that do get chosen will perform at the same rates as the general markets anyway.

Don’t be Fooled By Mutual Funds Lies

In order to justify the fees, actively managed mutual funds have to consistently outperform the markets…and studies show that on average, they dont…and you can’t relieble pick the mutual funds that will at any given time.  Why not invest in a passively managed index fund or two that track the markets almost dollar for dollar and pay a small percentage of fees?

It’s mostly due to convenience, lack of education and knowledge, and what Dr. Edesess describes as ‘The Big Investment Lie’…  The idea that investing is so complicated that we have to have a professional tellin gus which mutual funds to buy in order for us to have any chance to make our investments work at all.  It’s just not true.

The other thing you’ll see is mutual funds claiming certain average rates of returns over a number of years. It’s true some mutual funds will be lucky enough to beat the markets. The issue is the unpredictability of which mutual funds will do it.  You also have to be critical of the claims.

If a mutual funds promoter claims an average of 10% yearly returns for 4 years, what would you think?  I certainly could be worse in today’s environment.  Using a simplistic calculation adding 10% to the principle and to the gains (Would be greater increase due to compounding.  We only added gains yearly to simplify the demonstration) and assuming you invested $100,000 four years ago into a mutual fund and didn’t add anything to it.  If there were actual 10% gains each year you’d have:

  1. $100,000
  2. +10% = $110,000 after one year.
  3. +10% = $121,000 after 2 years.
  4. +10% = $133,100 after 3 years.
  5. +10% = $146,410 at the end of four years for a $46,410 gain…a 46.4 % increase in 4 years.

But what if what actually happened was that the fund lost 30% in year one and gained 30% year 2, 30 % year 3, and 30% year 4.  Starting again with $100,000:

  1. $100,000
  2. -50% = $50,000 after year one.
  3. +30% = $65,000 after year two.
  4. +30% = $84,500 after year three.
  5. +30% = $109,850 at the end of year four years for a gain of $9850…a 9.85% increase over 4 years.

Both of these scenarios represent an ‘average of 10% per year’. (-50+30+30+30=40/4 yrs = 10%) but there’s a difference of 36.55%.  We’re talking $36,550.00

Look closely at any claims made by mutual funds trying to convince you to buy into them. You also may be told they are the best way to ‘diversify’ but there are low cost passively managed index funds that track virtually all stocks in a market…and it’s not as hard for the individual investor to get exposure to metals, currencies, commodities and real estate as you might think.  True diversification must expand beyond mutual funds and paper securities and bonds.

Take Action

You’ve already taken the first step in reading articles like this one about mutual funds…you need to learn as much as possible about your own finances and investing, including mutual funds.  No one cares more about your money than you do.

Ask your broker or advisor about low cost passively managed funds that track the markets as a utual funds alternative.  (Think about both foreign and domestic markets.) Also ask about how your advisor or broker gets paid and where the fees taken from your account are going…especially if you own mutual funds and other actively managed funds.  You need to understand this if you want to look into cutting those fees.

Education is key to sound financial management and control over your future.

Happy investing!

Roderick MacKenzie is a top tier wealth education and business consultant at Business TM.  He provides education regarding the  financial management and business strategies needed to join the ranks of the wealthy.  He would be happy for you to contact him with any questions about financial and/or business education.

Comments (3)

  1. Single mom Says:

    April 18th, 2010 at 4:22 am

    What a great post. The more I read on this site the more I like it. Simple, straightforward advice and it works.

  2. Clickbank eBooks Says:

    April 18th, 2010 at 1:29 pm

    I wouldn’t say I completely agree regarding some issues, but you definitely have an interesting writing style. Anyway, I appreciate the quality you bring to the blogosphere and that this isn’t just another abandoned, made-for-adsense blog! Take care…

  3. Smartypants Says:

    May 13th, 2010 at 2:03 am

    Love it. The truth. Step 1 – Fire your financial advisor.

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