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Thayer Partners Blog

Mutual Funds: Are You Paying for Underperformance?

[fa icon="calendar"] Jul 18, 2016 9:00:00 AM / by Chris Wilmerding

Chris Wilmerding

Mutual_Funds-_Are_You_Paying_for_Underperformance.jpgIf you’re like most people saving for retirement, then you probably have some mutual funds in your portfolio. And, like most people, you’re probably paying for the underperformance of those funds.

Yes, you read that right—you’re paying extra to have funds that actually underperform the market.

Traditional Mutual Funds

For years, the financial industry has told people that they must invest in actively managed funds. Actively managed funds are just that: managed. There’s a team of highly paid people buying and selling equities, in an effort to beat their benchmark and get the maximum return possible. The idea is that by paying someone to study the markets and companies in those markets and to decide which stocks to buy and which to sell, the fund will perform better than a fund that is designed simply to track the market. The watchful eye of a highly skilled and talented portfolio manager should lead to market beating returns.

But Does It Work?

In a word: no. Actively managed mutual funds fail, for example, to outperform the S&P 500 anywhere from 50% to 90% of the time. That’s right—anywhere from half to almost all actively managed funds fail to meet their benchmarks. Currently, about 89% of U.S. equity funds and 90% of U.S. fixed income funds fail to meet their benchmarks over a 10-year period.

Why Do Funds Fail?

There are some very good reasons why most actively managed funds fail to outperform their benchmarks, namely transaction costs, taxes, and fees. Think about it: If your fund is actively managed, that means someone is hired to decide when to buy, sell, and so on. Trading costs can rack up quickly, as will taxes. The biggest problem, however, is actually the cost to employ the portfolio managers, themselves, who tend to be highly paid professionals.

The portfolio manager’s salary is deducted monthly from the money invested in the mutual fund. In fact, the average expense ratio for most actively managed funds is somewhere around 1% or more. That means if you have a portfolio worth $1 million invested in actively managed mutual funds, you could be paying upwards of 1% per year in fees. That’s $10,000—for results that will likely underperform the market.

What Can You Do?

It’s become engrained that your funds have to be actively managed. After all, mutual fund companies spend a great deal of money advertising the positive performance of their funds. However, you don’t often (as in, ever) see them advertise funds that underperform the markets. Mutual fund companies sell the hope and optimism that you will be one of the lucky few that will actually beat the market over a long period of time.

So what can you do instead? One option is buy indexed mutual funds or ETFs, those that track the market (less modest expenses and tracking error). These funds aren’t actively managed by teams of portfolio managers, but instead are passively managed by computer systems that automatically maintain the right weightings so that fund tracks the performance of its benchmark. This means these funds cost a lot less to run than actively managed mutual funds.

But Is an Index Fund Better?

For all but the very best hedge fund managers, yes. While going with an index fund doesn’t guarantee positive returns—you can still go up or down, depending on the market—what it does is slash fees and expenses and is designed to deliver the performance of the market it tracks. It also puts you ahead of about 90% of the people who invest in active mutual funds.

Generally, index funds have expense ratios of 0.05% to 0.20%. That’s almost a percent less than the average actively managed fund! In a hypothetical $1 million portfolio, that would amount to fund expenses of around $500 to $2,000 per year and savings of $8,000 per year or more, savings that stay in your portfolio and help it grow.

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This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

ETFs trade on one of the major stock markets and can be bought and sold throughout the trading day, like a stock, at the current market price. And, like stock investing, ETF investing involves principal risk—the chance that you won’t get all the money back that you originally invested—market risk, underlying securities risk, and secondary market price.

Topics: Mutual Funds

Chris Wilmerding

Written by Chris Wilmerding

Chris Wilmerding is Principal of Thayer Partners, an independent investment management firm located in Westwood, MA providing financial planning and wealth management counsel to individuals and their families.

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