In the February 2007 edition of The Blue Chip Investor, Steven Check from Check Capital writes

“Dalbar, Inc., is famous for examining how individual investor behavior impacts returns. A recent Dalbar study stated that equity mutual funds, over the 20-year period ending 2005, earned annualized returns of 11.0%. However, its findings revealed that mutual-fund investors only achieved returns of 3.9% per year. How is this possible?

Instead of “buying low / selling high,” investors bought “hot” funds high (following short-term excellent performance) but then sold low (after performance inevitably lagged.)

In addition, investors went heavily into cash at times when uncertainty prevailed - such after the 1987 crash or 9/11 - only to watch the market subsequently soar.”

John Bogle, founder of The Vanguard Group and creator of the index fund, said the following in a speech to Financial Analysts of Philadelphia on February 15, 2001 (source: Wikiquote)

“Yes, the investor is often his own worst enemy. Yes, the marketing colossus known as the mutual fund industry provides the weaponry which enables investors’ to indulge their suicidal instincts. No, the fund industry was hardly an innocent bystander in the market boom and the subsequent carnage. “We have met the enemy and he is us”… all of us.”

I know there have been times when I’ve been my own worst enemy when investing in mutual funds, like for example, when I sold the Oakmark Select Fund toward the end of 1997.

As far as I can remember, I had purchased it six to nine months before, and it hadn’t really done much during that time. At least that’s why I remember selling it.

Turns out this is pretty typical when you go chasing after the latest “hot” fund instead of picking consistently performing funds and sticking with them over a longer period of time.

If you’re not sure what a mutual fund is, you can read more about them here.

5 Things You Must Know Before Buying a Mutual Fund

I know you’ve probably heard it a million times… past performance does not guarantee future results, and that’s very true, particularly in the short term.

But past performance is the only real way most investors have to tell how well a fund is managed. And that’s what you are really buying when you purchase a mutual fund, the expertise and experience of the mutual fund management team.

BusinessWeek has an interesting article, where the authors of The Great Mutual Fund Trap argue that actively managed mutual funds are typically bad investments, especially for novice investors.

Their argument is based on the fact that the average return of all actively managed funds is typically lower than that of the general market. For example, in the ten year period that ended in 2001, the average annualized performance of actively managed mutual funds trailed the S&P 500 by about 1.7%.

Part of the problem, they claim, is that active fund managers try to “beat the market” and that, invariably, leads to periods of overperformance, followed by periods of underperformance where the funds regress back to the mean. When you add the costs involved in managing mutual funds, it becomes more difficult for the average investor to make a comparable return to the general market.

Instead of buying an actively managed fund, they advise you to buy an index fund, which is a fund whose only objective is to match its corresponding market index as closely as possible. Instead of trying to beat the market, you should be happy with mere “market performance” at lower cost and risk.

Their argument makes a lot of sense, particularly for novice investors, but it also has some weaknesses.

They claim that mutual fund managers are like coin tossers, with random probability of beating (heads) or underperforming the market (tails). When you see a fund beating the market for several years in a row, they argue that it’s not necessarily skill, but mostly good luck. Luck that will invariably run out.

I’m not so sure that coin-tossing is the best analogy, I think it’s probably closer to poker. There is definitely some luck involved, and even the best manager won’t beat the market every time, but skill, knowledge, and experience still play an important role.

Just like the best poker pros will tend to make it to the final tables more often than not, over the long-term, the best fund managers will also distance themselves from the rest of the pack.

The problem for the typical investor becomes: how do you pick the best fund manager?

This is why the authors of The Great Mutual Fund Trap call it a bad investment. If you can’t pick winning stocks, what makes you think you can pick a winning fund manager?

The way a typical mutual fund investor picks funds, they are probably right!

So, assuming that you want to invest in an actively managed mutual fund rather than a simpler index fund, here are five things that you need to know before buying…

1. Long-term past performance - When looking at past performance, many investors rely on 1-year or 3-year performance ranks, but for the most part, this results in chasing the latest hot fund.

Instead of looking at short-term performance, focus on long-term performance of the fund. Look at 5-year, 10-year, and lifetime performance numbers because they are much more likely to give you a broader picture of how the fund performs in different market conditions.

While it’s true that these past performance numbers may be meaningless if investment philosophies that worked for the past 20 years will no longer work in the future, I think this is unlikely to happen.

This means that you should probably not buy a recently launched fund that has little historical performance data unless you already know something about the fund managers.

2. Consistent performance over time - Looking only at 3, 5, and even 10-year average annual returns for a fund can be misleading.

The reason is that getting extremely lucky one year can skew the results and make them seem much better than they actually are.

For example, take the following numbers: 8, 3, 37, 2, 5

Their average is 11, but there is only one instance where this average is exceeded. All the other values are lower, or much lower than the average. That one really good value (37) skews the average to make it seem much better than it actually is.

A good way to check for consistent performance of a fund, is to look at Year by Year total returns of the fund compared to its benchmark index. The more data you can compare, the better.

For example, here is the historical total return data for the Dodge & Cox stock fund over the past 10 years:

 

As you can see, this fund has performed very well compared to its index (S&P 500) beating it 7 out of 10 years, and by a very good margin on 4 of those 7. In the underperforming years, only 1 year (1998) is truly bad compared to the index, with the others being just slightly behind.

The standardized performance returns also reveal a similar pattern compared to the S&P 500, with a 10 & 20 year annualized return performance of 14.23% and 14.81% respectively, compared with the S&P 500 returns of 8.42% and 11.80% over the same period.

Since you are buying the expertise and experience of the fund management team, you also need to examine how much of the past performance has occurred under the current fund management team.

Having a recent change in the fund management is not necessarily a deal-breaker, but it is a red flag that you need to carefully consider before purchasing.

3. Fund expenses - Mutual funds make their money by charging a percentage of the total amount invested in the fund. These are called the Annual Operating Expenses expressed as a percentage. For example, the Dodge & Cox stock fund has an expense ratio of 0.54%, which is significantly lower than the category average of 1.35%.

Index funds have some of the lowest expense ratios because the fund management is not actively involved in the selection and purchase of stocks. They just follow the index.

Operating expenses are important because they affect the potential returns of the fund. These expenses are already incorporated into the performance figures of the fund.

For example, a fund with an expense ratio of 2% would have to beat the Dodge & Cox stock fund performance by 1.46% each year to provide the same return to the investor.

In addition to the annual operating expenses, a fund may also impose additional fees called Front and Back Load, which are charged when you buy (front) or sell (back) shares in the fund. These fees are typically not included in the fund performance numbers and can significantly reduce the actual returns for investors.

With the large number of no-load mutual funds available today, there is absolutely no reason to purchase a mutual fund that contains any type of load, front or back.

Many fund companies also have an additional fee called a 12-b-1 fee (also expressed as a percentage of total fund assets) that is used to cover marketing, advertising, and other related fund expenses.

These marketing fees are something else to consider when shopping around for the best mutual fund to buy.

4. Turnover ratio and tax cost ratio - Turnover ratio represents the percentage of fund assets that have changed over the past year.

A high turnover ratio means the fund manager is actively trading assets in the fund, buying and selling stocks, while a low turnover ratio is more consistent with a “buy and hold” strategy.

The tax cost ratio represents the percentage point reduction in annualized returns that a typical investor can expect due to income taxes from the mutual fund distributions.

These two values are important if you are buying a mutual fund for a taxable account, because they can significantly reduce your overall returns over time due to income tax.

For tax-free or tax-deferred accounts like IRAs & 401Ks, the turnover ratio and tax cost ratio are much less important.

Because of their nature, index funds tend to have very low turnover and tax cost ratios compared to actively managed fund, which is another reason they are attractive for taxable accounts.

5. Asset Allocation and Diversification - One of the main benefits of mutual funds is that they provide diversification across a large number of stocks in various sectors.

Diversification reduces your risk exposure to the failure of any one stock. Think Enron, and all the people that lost their life savings because they had all their eggs in the Enron basket.

However, not all mutual funds are equally well diversified. Some funds are highly concentrated in a specific sector (like technology, healthcare, or energy), while others purposefully hold a much smaller number of stocks than the average fund.

You need to read the fund’s prospectus to determine how well the fund is diversified.

Financial planners recommend diversifying your holdings even further by buying several mutual funds that focus on different types of assets. This is called asset allocation.

For example, you may divide your investments between funds specializing in large capitalization stocks, small capitalization stocks, and international stocks.

Asset allocation strategies are beyond the scope of this article, but you can find out much more about it, and everything else related to mutual fund investment, in a great book called Charles Schwab’s Guide to Financial Independence.

You need to consider diversification and asset allocation when buying a new mutual fund because it is possible to believe you are diversifying your investments when you are actually not.

For example, if your new mutual fund invests in very similar stocks, sectors, and asset types as another fund that you own, then you are not really diversifying because both funds are exposed to the same risks.

Look at the top ten holdings and sectors that your fund invests in so that you can compare it with your other existing funds.