Why do some mutual funds underperform?
And how do you avoid investing in those funds?
Have you ever wondered what to invest in? You’re not the only one! There’s a lot of information out there and it’s hard to know whether you’ve made the right investments. So in this article, we’ll explore why some mutual funds underperform.
Funds can underperform for many different reasons. And the problem is knowing whether it was just bad luck or a sign you should reallocate your portfolio. Fortunately, help is available. As always, I suggest all my clients reach out to an investment pro since it’s critical to get retirement investing right.
But for those who want some initial pointers to analyze their portfolio, I’d like to give you some starting pointers to figure out whether your funds are likely to underperform or not.
What are mutual funds?
Before we examine why mutual funds underperform, let’s take a look at what funds are.
In short, mutual funds are a shortcut to investing in many different companies at once. Essentially, a mutual fund will pool investor money and invest it on the owner’s behalf. Who decides how these funds are invested?That’s the job of a fund manager.
Fund managers will oversee these mutual funds and dictate how the fund will be invested. They’re usually highly experienced professionals, and they often have several analysts to help review investments. The typical mutual fund might invest your money in 70+ companies, and they would do it in the hopes of diversification AND outperforming the market. Not bad for a single investment, right?
But mutual funds can underperform too
Just as many funds outperform their benchmarks, many funds also underperform. It’s a simple mathematical truth: half of all funds are going to be below average. In fact, many mutual funds don’t even exceed their benchmarks (i.e. you would be better off investing in a low-cost index fund!)
Why underperformance matters to YOU…
Underperforming funds can cost you tens of thousands of dollars over the course of your lifetime. Even a small 2% difference per year can turn into a massive amount over time.
- $10,000 invested at 9% for 35 years turns into $204,140
- The same $10,000 at 7% for 35 years turns into $106,766
The difference is DOUBLE! No wonder it’s so important to avoid funds that underperform.
Yet avoiding underperforming funds is WAY easier said than done.
Why not just avoid funds that underperformed in the past? That’s actually not a bad strategy, but it’s also not entirely complete. That’s because even the best-performing funds might underperform in the future. They could have gotten lucky. Or worse, they bought stocks that went up a lot and are now due for a correction.
How to avoid underperforming funds?
So if you can’t judge a fund by its past performance, how do you avoid underperforming funds?
Here’s what Morningstar, a research firm, has to say.
Overall, the results strongly indicate that long-term investors should not select funds based on past performance alone. Rather, they should combine performance analysis with an assessment of other quantitative and qualitative factors, such as the fund’s fees, the quality of its investment process and management team, and the stewardship practices of the asset management firm. This more holistic approach should improve investors’ odds of success.
Choose well-managed funds
One strategy is to pick funds with good management. Every mutual fund publishes what’s called a prospectus, a lengthly written document that tells you what the fund invests in. Don’t worry, you don’t have to read it all. Instead, flip to the first couple pages and scan through the introduction. You’ll often get a great deal of information about the fund’s management there.
- Management. Does the fund manager have a good track record?
- Support. Does the fund have adequate analyst support?
- Communication. Is the fund manager communicative about his/her thoughts and actions?
Know what to avoid
I always say I want to know where I would die so I can never go there – Charlie Munger
Often, the best way to avoid underperforming funds is to understand WHY they do so. Because once you understand the reasons why many funds underperform, you can use that knowledge to avoid them.
Why do funds underperform?
There are three key reasons why some funds underperform
1. Funds worry about being different
A 2012 study by Morningstar found incredible correlations between mutual funds and their benchmarks. (Benchmarks are the milestones that fund managers are judged against. A fund manager specializing in large-US stocks, for instance, might be benchmarked against the S&P500, an index of the 500-largest US companies).
…and that makes them too average
The findings are eye-opening. The correlation between mutual funds and their benchmarks have almost converged to 1.00! This means the majority of mutual funds now perform just like the market. So why not just buy a low-cost index fund and avoid the headache?
One of my former co-workers, a portfolio manager, put it in excellent terms. “In fund management, it’s better to fail conventionally than to fail unconventionally.” In other words, no one will fire you for owning shares in Apple. But lose the same amount from doing things differently, and suffer the wrath of angry customers.
Want proof? Let’s put you in the driver’s seat for a moment.
A case study: Vista Outdoor Sports
Vista Outdoor is a US-based company that sells sports gear and ammunition. Half of their revenue comes from well-known, yet stodgy, brands like Camelbak, Giro and Bell. Their products are ubiquitous on the shelves of sporting goods stores.
The other half of their revenue comes from a dirty little secret: the company earns half its revenues from firearms and ammunition. They own brands including Federal, Savage, American Eagle and CCI.
In 2013-15, America underwent massive ammunition stock-piling, followed in 2016 by a demand crash. The company is now losing money, and unsure whether ammunition demand will recover to its original levels.
How would you decide?
- Choice 1: your $5,500 investment could either go UP to $24,000 or DOWN to $2,750 in 3 years
- Choice 2: your $5,500 investment could be at $9,000 in 10 years
What would you do? You could go with Choice 1. But what if Vista goes bankrupt? What would you tell your investors?
You want to avoid funds that instinctively turn to Choice 2. Easier to explain 1-2% underperformance to clients than a 50% loss in the fund. But it’s often the wrong decision for the client!
2. Some funds don’t take calculated risks.
Investing in an index fund is akin to throwing up your hands and saying “It’s too difficult! I’ll just buy a little bit of everything!” It’s not a bad strategy, but it’s not the best either. Yet investment managers do this consistently. It turns out that the average mutual fund has a 97% correlation rate with its benchmark. Ninety-seven percent! Now that’s clearly not working, since mutual funds need to make up the fees they charge, which range from 0.5-2.0% of assets.
To avoid market-hugging mutual funds, you need to check out a fund’s active share. That’s the % difference the mutual fund is from its benchmark. For example, an index fund of the S&P 500 will have zero percent active share, while a fund that’s invested entirely in Apple stock will have a 96% active share (since Apple makes up ~4% of the market).
Mutual funds typically report their active share in their marketing materials, and you’re looking for funds with at least a 25% active share.
3. Some funds grow too large
That’s important because larger funds quickly become unwieldy and unable to invest in great deals. In other words, while small funds can concentrate on 10-20 great companies, large funds are forced to invest in 80+ mediocre funds just to make up their size.
Try to avoid funds larger than $20 billion if they’re investing in large global markets. If they’re investing in small companies or smaller, emerging stock markets, you’ll want an even smaller fund, down to $1 billion.
How to know if YOUR funds are performing well?
I’ll give you the same advice I give to everyone: you need to make sure your investments are DONE RIGHT. That’s because financial mistakes made today often takes YEARS to show up. By then, it’s often much harder to change course. That’s why I recommend that you talk to an investment pro to help analyze your fund performance at least once a year.
Want more help investing?
If this seems like a lot of information, don’t worry. The great news is that we’re here to help you invest in the right funds. Rather than worry about investing yourself, all it takes is a phone call to get in touch with a pro investment advisor today.
Where to find more resources
If you’re looking for even more investment tips, you’ve come to the right place.
That’s because I’ve helped invest client money for over a decade in the same old-fashioned way: seek out great companies in great industries that can be purchased at a discount to their fair value. Sounds too simple to be true? Give me a call today and I’ll show you that it’s still possible after all these years.
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