Copywritten by Equitrend, Inc. in 2006.
About 75% of fund managers are not able to beat the S&P 500 year after year. How can a basket of 500 stocks do better than most mutual funds that are actively managed? Most of the time, the people in charge of these funds are very smart. They have a lot of education and can use the world's most advanced information and decision-making systems. So why do they not do better than the S&P 500?
Quick Check:
Here's a very simple way to measure how well a manager is doing: Let's compare the performance of Morningstar's domestic stock mutual funds to that of the S&P 500 index for one, three, five, and ten years, starting on April 30, 1995. The S&P 500 index is a good way to compare large companies in the United States.
Our results:
—Out of the 1,097 funds that Morningstar looked at for a year, 110 beat the S&P 500 and 987 didn't. Results ranged from 46.84 percent to -32.26 percent, while the S&P 500 had a 17.44 percent return.
—Over the three-year period, the S&P 500 returned 10.54 percent, while the funds' annualised returns ranged from 29.28 percent to -15.02 percent. Only 266 of the 609 funds beat the S&P 500.
When we look at the last five years, 204 of the 470 funds beat the S&P 500. The results ranged from 27.35 to -8.51 percent, and the index went up by 12.62 percent.
At ten years, only 56 out of 262 funds beat the index. Their results ranged from 24.77 percent to -4.06 percent compounded annually, while the S&P 500 returned 14.78 percent.
It shouldn't be a surprise that most funds don't do better than the stock market as a whole. Since most of the money invested in the stock market comes from mutual funds, it is mathematically impossible for most of these funds to do better than the market as a whole.
Investors in actively managed mutual funds are given the impression that, in exchange for higher fees than index funds, the actively managed fund will do better in the market. There are a lot of things that make it hard to keep this implied promise.
Here are some of the problems:
—It's harder for a mutual fund to do well the bigger it gets.
—Fund size hurts performance, but fund managers have a strong incentive to let the fund grow as big as possible because the bigger the fund gets, the more money the fund managers make.
—The best mutual fund managers are usually hired by hedge funds, where the pay is better and there are fewer rules about how to invest.
Mutual funds are required by law to be conservative, which, in theory, keeps their losses to a minimum. Because they tend to be cautious, they usually can't use arbitrage, options, or shorting stocks.
Can You Make It Better?
Most mutual funds are not very flexible and have a lot of rules. Because of this, your investment capital is not well protected against changes in the market. Most of the time, if you compared the beta of the equity exposure in actively managed mutual funds to an equal equity exposure in the S&P 500 index, buying an equal equity exposure in the S&P 500 index would give you a better reward-to-risk ratio. So, the answer is that you can do better and beat the S&P 500 if you use a good system for timing the stock market.
