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TRANSCRIPT:
In prior videos we've established that you'll want both stocks and bonds, from many, diversified companies, and that you need to avoid market timing.
Mutual funds are definitely the convenient way to invest in hundreds, or even thousands, of diverse companies. So, how do we recognize a good mutual fund from a bad one?
This is where our instincts get us in trouble. We are comfortable using rating systems to guide our other purchases. So most people are attracted to mutual funds rated four or five stars by Morningstar.
Here's an actively-managed fund that tries to beat the market return, and a passively-managed fund that attempts to match the market return.
A key point that I want you to understand is that these rankings are based on past performance so have very little relevance!(1)
Here's why. Remember, "the Market" is the collection of all stocks, all investors. So for every active manager who beats the average market return, another loses by the same amount. Unfortunately, the only way to profit from those winning funds is to know the winners in advance, which is impossible to know.(2)
There are a variety of reasons why the winners don't enjoy persistent success. Sometimes success attracts an over-whelming amount of new money to a fund. Sometimes the manager's style of investing goes out of favor. And sometimes the manager was never good, just lucky, and their luck runs out.(3)
In contrast, Index Funds are passively managed and can be very low cost. An index fund simply owns all the stocks that make-up an asset category, or in this case, all asset categories. The goal is not to beat the market, but to match the market return as measured by a benchmark index. For instance, the S&P 500 is a benchmark index for the 500 largest companies in the United States. A different, broader index benchmarks the entire stock market.
Active funds require a talented staff, excellent insightful research to try to predict which companies will outperform tomorrow, and frequent trading. All these expenses get paid first; investors just get what is left. So to beat the market after subtracting these costs is very challenging. Only 37% of active funds beat the market every year.(4,5) But there is little persistence and within five years the number of winners has dropped to 25%. Over a period of 10 years, a mere 15% of the actively managed funds beat the "market return", which is what you would get if you had invested in a low-cost highly-diversified index fund.
Imagine that you want to invest 10,000 dollars and there are only nine mutual funds in the world.(6) Eight of them are active funds with an annual cost of 2%. One of them is a low-cost index fund which closely tracks the overall market return.
You are clairvoyant and can foresee that you have 2 out of 8 chances of outperforming the market over the next five years, and you know the odds will decline further with time.
The reward for such long odds is an extra two or four thousand dollars. But the average return from all the active funds is less than the market return by $1300 — the same as the amount subtracted for expenses.
You have this information, so you further notice that if it wasn't for those expenses, four of the active funds would beat the market, and four would not. And, averaged together, the eight active funds would have achieved the market return. After all, that's what the market return is, by definition.
You can know the odds. You can know the arithmetic. But you can't know in advance which funds are going to outperform so we'll cover them up. You are going to have to guess. Do you want to invest in the index fund and get the average market return, or do you want to try to beat the market with one of the active funds. And, if so which one?
Congratulations if you chose the index fund. It shows that you are a rational, risk-averse investor.
Now, do you agree with me that this ranking might be a little misleading? Five stars for a fund that outperformed recently, but has a very low chance of outperforming over the next ten years? And of course the index fund is only rated mid-pack: It can't outperform the market; it tracks the market!
The best predictive measures of a fund's future performance are its costs, and how closely it tracks the market.(7) Now, do you think that you don't have costs because you only buy "no load" funds? Watch the next video.
Find other explanatory videos, smart tips, and links to useful resources at FinancingLife.org.
FOOTNOTES AND VIDEO PRODUCTION CREDITS
Special thanks to Jennifer Howell for her valuable feedback and encouraging words.
(1) Morningstar explains their rating system in this pdf: http://corporate.morningstar.com/us/documents/methodologydocuments/factsheets/morningstarratingforfunds_factsheet.pdf
(2)The Arithmetic of Active Management, William F. Sharpe
http://www.stanford.edu/~wfsharpe/art/active/active.htm
(3) All About Index Funds, by Richard A Ferri, 2nd Edition, McGraw-Hill, 2007, p.26.
(4) All About Index Funds, by Richard A Ferri, 2nd Edition, McGraw-Hill, 2007, p.25.
(5) The Case for Indexing, Vanguard, February 2011
https://institutional.vanguard.com/iwe/pdf/ICRPI.pdf
(6) This "outfox the box" game was originally presented by Bill Schultheis in his delightful little book, The Coffeehouse Investor: How to Build Wealth, Ignore Wall Street, And Get On With Your Life (Palouse Press, 2005). I added details to make this example consistent with typical fund expenses, and consistent with the odds of beating the market in five years.
(7) The Little Book of COMMON SENSE INVESTING, by John C. Bogle, John Wiley & Sons, Inc., 2007, p. 189.
The opening/closing music "Because" is by David Modica from his Stillness and Movement album, published and licensed by www.Magnatune.com.
Photo "Contemplation au sommet de la Fache" is by Vinvin F. via www.flickr.com with this Creative Commons license BY-NC-SA 2.0 .
The closing photo "Trees in the Fog" is by Yann Richard under the terms of the Creative Commons BY 2.5 license.
This video may be freely shared under the terms of this Creative Commons license BY-NC-SA 3.0.
Video copyright 2008-20011 Rick Van Ness. Some rights reserved.
