How To Lose Money In The Market

Do most mutual fund managers add value in their attempts to identify 'mispriced' securities? 

Based on a recent analysis of the CRSP (Center for Research in Security Prices) Mutual Fund Database returns data through 2012, we have a pretty good idea of the answer.

This CRSP report documents survivorship and performance in the U.S. mutual fund industry, and illustrates the negative impact of high fees and turnover on returns.  In summary, for the periods examined:

*Outperforming funds were in the minority
*Strong track records failed to persist
*High costs and excessive turnover may have contributed to underperformance

The underperformance among mutual funds points to an important guiding investment principle:  Choosing a long-term winner involves more than seeking out funds with a successful track record, since past performance offers no guarantee future success.  Investors must consider other variables, including a mutual fund’s underlying market philosophy, investment objectives, and perhaps most importantly, cost. 

The competitive landscape makes the search for future winners a formidable challenge. Confronted with so many fund choices – and lacking an investment philosophy to guide their search – some investors resort to picking funds that have strong track records, reasoning that past outperformers will continue to outpace their benchmarks.

According to the CRSP analysis, only about a quarter of the equity funds with past outperformance during the initial three-year period (2007-2009) continued to beat their benchmarks in the subsequent three-year period (2010-2012).  The results for funds with good five- and seven-year track records were similar – only about a quarter beat their benchmarks in the subsequent period.

So, do most mutual fund managers add value in their attempts to identify 'mispriced' securities?  This CRSP analysis of U.S. mutual fund industry performance tells us the answer is a resounding, "No!"  It’s more proof that a broad, low cost investment approach is the best one.

Silver Anniversary Of A Crash

The stock market was down just under 2% today, Friday October 19th.  Not a good day, but relative to 25 years ago, a GREAT day.

I recall October 19, 1987 quite well.  That was the day the Dow Jones Industrial Average dropped over 500 points in one day, which at the time was over 20%.  Think about that - a similar drop today would mean the Dow would fall over 2500 points!

Can you imagine the near and maybe real panic that would cause today, in the U.S. and around the world?  People would be non-functional.  At least the 40+% drop in the stock market in 2008 was more of a cascading crash, since it happened over the course of many weeks/months.

25 years ago, I was less than two years out of college, working an entry-level job setting up 401k plans for employer-customers at Principal Financial Group in Des Moines.  Oh, and I had just found out we were expecting our first child.  But I never felt like I was in danger of losing my job - if anything, there may have been more job security.  Principal needed more help after that, as the 'yuppies' of that generation suddenly concluded they should be saving more money (inside a 401k plan was one way) instead of spending every dime they made.

Looking back, one of the crazy things about that day was we were not in the 24-hour news cycle that we are today.  We weren't following the crash using TVs or the internet (the what?).  We just got periodic updates throughout the day, near the end of which we learned of the 500+ point drop.

One of my favorite stories from that day actually didn't happen until the next day, when we were ushered into a meeting with some Principal executives, who told us to tell employer-customer not to be alarmed, it was 'business as usual' there - except now we weren't going to do this, or this other thing, or that, or that other thing. In other words, it was the opposite of business as usual.  Clueless morons!

In the end, the market and the economy came back stronger than ever, setting up the 90s for another big bull run.  Is that why people think the current recovery seems non-existent - because it isn't happening fast enough?

The Less You Give, The More You Receive

On July 1, 2012, group retirement plan service providers are required by law to more fully disclose their fees.  These long-awaited federal regulations are primarily focused on 401(k) plans, to give both participants and sponsoring employers a more transparent view of the fees they are paying.

Why is this important?  Because whether you’re a 401(k) plan participant or not, low fees are at the heart of a good investment outcome for any portfolio.

According to a 2010 Morningstar study ¹ that encompassed a 5-year look-back period, low-cost funds categorically outperformed high-cost funds.  In fact, in every asset class over every time period, the least costly quintile of mutual funds produced higher total returns than the most expensive quintile.

Morningstar went so far as to say that expense ratios were the most dependable predictor of performance.  “Investors should make expense ratios a primary test in fund selection,” the study concluded.  “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision.”

As with 401(k) plans, the only way you can know whether your investment fees are low is to determine what those fees are, and how they compare with others.  If you have any doubt, contact someone who can help.