Chapter Five

The Grand Illusion

Surprise! The Returns Reported by Mutual Funds Aren’t Actually Earned by Mutual Fund Investors.

 

 

 

 

IT IS GRATIFYING THAT industry insiders such as the Investment Company Institute’s (ICI’s) chairman Jon Fossel, Fidelity’s Peter Lynch, Mad Money’s James Cramer, and AQR’s Clifford Asness agree with me about the inevitable inadequacy of returns earned by the typical equity mutual fund relative to the returns available simply by owning the stock market through an index fund based on the S&P 500. But the idea that fund investors themselves actually earn those returns proves to be a grand illusion. Not only an illusion, but a generous one. The reality is considerably worse. For in addition to paying the heavy costs that fund managers extract for their services, the shareholders pay an additional cost that has been even larger.

During the 25-year period examined in Chapter 4, the returns we presented were based on the traditional time-weighted returns reported by the funds—the change in the asset value of each fund share, adjusted to reflect the reinvestment of all income dividends and capital gains distributions. But that fund return does not tell us what return was earned by the average fund investor. And that return turns out to be far lower.

Hint: money flows into most funds after good performance, and goes out when bad performance follows.

To ascertain the return earned by the average fund investor, we must consider the dollar-weighted return, which accounts for the impact of capital flows from investors, into and out of the fund.¹² (Hint: money flows into most funds after good performance is achieved, and goes out when bad performance follows.)

When we compare traditionally calculated fund returns with the returns actually earned by their investors over the past quarter century, it turns out that the average fund investor earned, not the 10.0 percent reported by the average fund, but 7.3 percent—an annual return fully 2.7 percentage points per year less than that of the fund. (In fairness, the index fund investor, too, was enticed by the rising market, and earned a return of 10.8 percent, 1.5 percentage points short of the fund return itself.)

Yes, during the past 25 years, while the stock market index fund was providing an annual return of 12.3 percent and the average equity fund was earning an annual return of 10.0 percent, the average fund investor was earning only 7.3 percent a year.

Compounded over the full period, as we saw in Chapter 4, the 2.5 percent penalty incurred by the average fund because of costs was huge. But the dual penalties of faulty timing and adverse selection were even larger. Exhibit 5.1 shows that $10,000 invested in the index fund grew to $170,800; in the average equity fund, to $98,200—just 57 percent of what was there for the taking. But the compound return earned by the average fund investor tumbled to $48,200, a stunning 28 percent of the return on the simple index fund.

And once again, the value of all those dollars tumbles because we must take inflation into account. The index fund real return drops to 9.0 percent per year, but the real return of the average fund investor plummets to just 4.0 percent. On a compounded basis, $76,200 of real value for the index fund versus just $16,700 for the fund investor—only 22 percent of the potential accumulation that was there for the taking. Truth told, it’s hard to imagine such a staggering gap, but facts are facts.

EXHIBIT 5.1 Index Fund versus Managed Fund: Profit on Initial Investment of $10,000, 1980-2005

While the data clearly indicate that fund investor returns fell well short of fund returns, there is no way to be precise about the exact shortfall.¹³ But the point of this examination of the returns earned by the stock market, the average fund, and the average fund owner is not precision, but direction. Whatever the precise data, the evidence is compelling that equity fund returns lag the stock market by a substantial amount, largely accounted for by their costs, and that fund investor returns lag fund returns by an even larger amount.

Inflamed by heady optimism and greed, and enticed by the wiles of mutual fund marketers, investors poured their savings into equity funds at the bull market peak.

What explains this shocking lag? Simply put, counterproductive market timing and fund selection. First, shareholders investing in equity funds paid a heavy timing penalty. They invested too little of their savings in equity funds during the 1980s and early 1990s when stocks represented good values. Then, inflamed by the heady optimism and greed of the era and enticed by the wiles of mutual fund marketers as the bull market neared its peak, they poured too much of their savings into equity funds. Second, they paid a selection penalty, pouring their money into the market not only at the wrong time but into the wrong funds. In both failures, investors simply failed to practice what common sense would have told them.

This lag effect was amazingly pervasive. In the past decade, the returns provided to investors by 198 of the 200 most popular equity funds of 1996 to 2000 were lower than the returns that they reported to investors! This lag was especially evident during the “new economy” craze of the late 1990s. Then, the fund industry organized more and more funds, usually funds that carried considerably higher risk than the stock market itself, and magnified the problem by heavily advertising the eye-catching past returns earned by its hottest funds.

As the market soared, investors poured ever larger sums of money into equity funds. They invested a net total of only $18 billion in 1990 when stocks were cheap, but $420 billion in 1999 and 2000, when stocks were overvalued (Exhibit 5.2). What’s more, they also chose overwhelmingly the highest-risk growth funds, to the virtual exclusion of more conservative value-oriented funds. While only 20 percent of their money went into risky aggressive growth funds in 1990, they poured fully 95 percent into such funds when they peaked during 1999 and early 2000. After the fall, when it was too late, investor purchases dried up to as little as $50 billion in 2002, when the market hit bottom. They also pulled their money out of growth funds and turned, too late, to value funds.

The problems of counterproductive market timing and unwise fund selection can be illustrated by observing the experience of the most popular growth funds of five giant fund families with the largest cash inflows, altogether more than $150 billion between 1996 and 2000 inclusive (Exhibit 5.3). During those five years, these aggressive funds provided spectacular records—annual returns averaging 21 percent per year, well above even the outstanding return of 18.4 percent on the S&P 500 Index fund. But during the five years that followed, in 2001 through 2005, retribution followed. While the index fund eked out a small gain (less than 1 percent per year), the returns of these aggressive, risk-laden funds tumbled into negative territory.

EXHIBIT 5.2 The Timing and Selection Penalties: Net Flow into Equity Funds

For the full 10 years, taking into account both their rise and their fall, the returns reported by these aggressive funds were actually quite acceptable—an average of 7.8 percent per year, nearly equal to the return of 9.1 percent for the index fund. But woe to the shareholder who chose them. For while the fund returns were acceptable, the returns of their shareholders were, well, terrible.

EXHIBIT 5.3 Growth Fund Returns versus Investor Returns: Aggressive Growth Funds, 1995-2005

Their average return came to minus 0.5 percent per year, in negative territory and a lag of fully 8.3 percentage points behind the funds’ reported per share figure. For the record, the annual return of the index fund shareholder, at 7.1 percent, also lagged the return of the fund, but by only 2.0 percentage points, far less than this group’s gap of 8.3 percentage points, or even the industry gap of 2.7 percentage points.

When the annual returns of these aggressive funds are compounded over the full period, the deterioration is stunning: a cumulative fund return averaging more than 112 percent; a cumulative shareholder return averaging negative 4.5 percent. That’s a lag of more than 117 percentage points! This astonishing penalty, then, makes clear the perils of fund selection and timing. It also illustrates the value of indexing and the necessity of setting a sound course and then sticking to it, come what may.

When ever-counterproductive investor emotions are played on by ever-counterproductive fund industry promotions, little good is apt to result.

The shocking performance of fund investors during the stock market “new economy” bubble is unusual in its dimension, but not in its existence. Fund investors have been chasing past performance since time eternal, allowing their emotions—perhaps even their greed—to overwhelm their reason. But the fund industry itself has played on these emotions, bringing out new funds to meet the fads and fashions of the day, often supercharged and speculative, and then aggressively advertising and marketing them. It is fair to say that when ever-counterproductive investor emotions are played on by ever-counterproductive fund industry promotions, little good is apt to result.

The fund industry will not soon give up its promotions. But the intelligent investor will be well advised to heed not only the message in Chapter 4 about minimizing expenses, but the message in this chapter about getting emotions out of the equation. The beauty of the index fund, then, lies not only in its low expenses, but in its elimination of all those tempting fund choices that promise so much and deliver so little. Unlike the hot funds of the day, the index fund can be held through thick and thin for an investment lifetime, and emotions need never enter the equation. The winning formula for success in investing is owning the entire stock market through an index fund, and then doing nothing. Just stay the course.

Don’t Take My Word for It

The wise Warren Buffett shares my view, in what I call his “four E’s.” “The greatest Enemies of the Equity investor are Expenses and Emotions.” Even Andrew Lo, MIT professor and author of A Non-Random Walk Down Wall Street (suggesting strategies to out-perform the market), personally “invests by buying and holding index funds.” Perhaps even more surprisingly, the founder and chief executive of the largest mutual supermarket—while vigorously promoting actively managed funds—favors the classic index fund for himself. When asked why people invest in managed funds, Charles Schwab answered: “It’s fun to play around. . . it’s human nature to try to select the right horse . . . (But) for the average person, I’m more of an indexer. . . The predictability is so high . . . For 10, 15, 20 years you’ll be in the 85th percentile of performance. Why would you screw it up?”

Mark Hulbert, highly regarded editor of the Hulbert Financial Digest concurs. “Assuming that the future is like the past, you can outperform 80 percent of your fellow investors over the next several decades by investing in an index fund—and doing nothing else. [But] acquire the discipline to do something even better: become a long-term index fund investor.” His New York Times article was headlined: “Buy and Hold? Sure, but Don’t Forget the Hold.”