Are Your Mutual Funds Falling Behind?  
Ron DeLegge, Editor
August 24, 2009

SAN DIEGO (ETFguide.com) – Even though stocks have surged since their March lows, many mutual fund managers and their investors have been falling behind.

This is explained, in part, by the latest S&P report card of active managers versus S&P indexes.

Over the past 5 years, Standard & Poor’s reports 68.75% of active large cap funds failed to beat the S&P 500 index (NYSEArca: SPY), 75% of active mid cap funds failed to beat the S&P MidCap 400 index (NYSEArca: MDY) and 67.37% of active small cap funds failed to beat the S&P SmallCap 600 index (NYSEArca: IJR).

How can you avoid falling behind?

Don’t Distort the Data
If 75% of active funds are outperformed by an index, don’t twist the data to make it something it’s not. The financial lesson you can take from this, is not that investors need to pick their mutual fund managers more carefully as those that suffer from data misinterpretation deficit would conclude. Here’s the real lesson: Trust the indexes and the financial products tracking them, not the portfolio managers that try to beat them and fail. Translation: Align your money with winners not losers.

If you own mutual funds, isn’t it time you found out how your funds have really performed versus corresponding index funds and ETFs? 

“The belief that bear markets favor active management is a myth,” stated the S&P report. The analysis also revealed similar results of bear market underperformance by mutual fund managers during the last downturn from 2000 to 2002.

If you still choose to invest in active funds or individual stocks, be sure to do it with extra money that you don’t care about. Your serious money should be invested in a diversified mix of low cost index funds.

Rewarding Failure
One of the key problems with mutual fund management is their convoluted business practices of rewarding failure. Instead of punishing bad behavior, they reinforce it. For example, in 2008, Mario Gabelli vacuumed in a $46 million paycheck from GAMCO Investors (NYSE: GBL) even though client assets at the firm fell by 33%. Despite the worst economic and market conditions of our generation, Wall Street’s fund executives are still cashing in like a bear market never happened. Mr. Gabelli is a Barron’s roundtable contributor and he presides over funds such as the Gabelli Equity Trust (NYSE: GAB) and the Gabelli Asset Fund (Nasdaq: GABAX).

 “Having a mutual fund management company is like having a toll booth on the George Washington Bridge all for yourself,” is what Marty Whitman, manager of the Third Avenue Value Fund (Nasdaq: TAVFX) told Forbes Magazine.
If that’s true, it looks like John Bogle’s “Designing a New Mutual Fund Industry” will have to wait a few more decades. Sorry Jack. In the meantime, all investors should immediately start re-designing their own investment portfolios to avoid getting victimized.

Who’s Protecting Who?
Instead of protecting mutual fund shareholders as they should be, mutual fund titans have resorted to 4th grade techniques, namely, finger pointing. In a recent letter to mutual fund shareholders, the Chairman of Fidelity Investments Edward C. “Ned” Johnson III, gave the financial services industry a severe verbal licking.  

"Although we ended 2008 better than a number of financial firms, it was a year of painful experience for the financial services industry, a period laced with toxic investment waste and the casual use of other people's money by a number of institutions," Johnson said.

What Johnson failed to mention in his criticisms was the most interesting of all.

Did you know that Fidelity’s fund managers more than doubled their ownership stake of floundering bailout kid, Citigroup (NYSE: C) during the fourth quarter of last year? As Citi was sinking, so were Fidelity’s equity mutual funds. In 2008, 64 percent of the firm’s stock funds were beaten by its peers. Is this the “toxic investment waste” Fidelity’s Chairman was referring to?

In contrast, index funds and ETFs have been “protecting” their shareholders during this vicious bear market. How? Quite simply, by not doubling and tripling up on dead-beat stocks like Citigroup. By design, stocks with the lowest market capitalizations have the least amount of influence on the performance of an index. 

The Performance Chasing Mafia (PCM)
There are others who claim they can find mutual funds that do beat the market. I classify them as official members of the performance chasing mafia or “PCM” for short. They remain utterly defiant (and aloof) about the relevant statistical facts, because they know better.

Take for example, Adam Bold, founder and chief investment officer of The Mutual Fund Store, a chain of 70 fee-only financial advisers. He recently told Bloomberg, “I’m a believer that by indexing, you’re accepting mediocrity. There are a limited number of people who have shown an ability to consistently beat the market year after year.” Earth to Adam! Earth to Adam!

The problem, which Mr. Bold doesn’t address, is that it’s next to impossible to accurately pre-identify top performing fund managers before they become top performing fund managers. That leaves people like Bold with one choice: To chase historical performance. Investors almost never get what they bargained for and performance chasing advisors get lots of fees. Nevertheless, Bold has made himself a very successful Wall Street career in helping people to identify yesterday’s winners, as his $4 billion monstrosity illustrates.

Finding Better Alternatives
Index ETFs are the solution to avoiding underperforming mutual funds. If you don’t want to be limited to ETFs that follow S&P stock indexes, there are other excellent choices to consider.

For example, Vanguard’s ETFs follow MSCI constructed indexes, which generally tend to be broader and more diversified because they own more securities. See the Vanguard Large Cap ETF (NYSEArca: VV), the Vanguard MidCap ETF (NYSEArca: VO), and the Vanguard SmallCap ETF (NYSEArca: VB). All of these Vanguard ETFs charge rock bottom annual expenses that range from 0.07% to 0.13%.

By aligning your money with the index funds, you avoid becoming a victim of systematic market underperformance. And while the rest of the investing population falls behind, you can get ahead!