4 Common Mistakes Made by Mutual Fund Investors
By Ron DeLegge, Editor
June 15, 2010

SAN DIEGO (ETFguide.com) – The investing public has placed an $11 trillion bet on mutual funds hoping to get ahead. Instead, many are falling behind.

1) Believing Distorted Performance Comparisons
Wall Street enjoys having the performance of its investment funds compared to inaccurate yardsticks. Not only does it help to distort true performance but it gives funds an artificial look of superiority.

Take recent analysis by Bloomberg, which concluded that only 2 of the 10 largest mutual funds in the U.S. are beating their primary benchmarks this year. (through early June 2010). It shows how even large media enterprises can be misled by true fund performance.

One of the funds Bloomberg analyzed is the Fidelity Contrafund (Nasdaq: FCNTX) whose performance was compared to the S&P 500, a large cap U.S. stock yardstick. Only problem is, FCNTX, a so-called domestic equity fund, had around 16% of its assets invested in international stocks at the end of April. The only way to fairly compare FCNTX’s true performance would be to use a blended benchmark of indexes that accurately replicate the fund’s asset mix over the same time period.

Because Wall Street uses misleading yardsticks of performance, such as peer group comparisons, incongruent indexes and other minutia, the public is misled.

Here’s the bottom line: The fund industry and analysts should be forced by the Securities and Exchange Commission to use blended benchmarks for an accurate measure of the performance for their funds. And furthermore, the Inspector Clouseaus running the SEC should’ve long ago had rules in place to enforce this.

2) Buying into Mutual Fund Ratings
Many people have the misinformed view that selecting mutual funds with the best performance, the most stars or the highest rating is the surest way to get ahead. But the facts say otherwise.

A gander at the marketing practices of the mutual fund industry are a good lesson in caveat emptor. Magazine covers and advertisements touting hot performing mutual funds with top rankings are everywhere. Unfortunately, these ads prey on unsuspecting buyers by giving them the false impression that top performing funds will consistently repeat their former success. “Star ratings have little predictive value,” states John Bogle, in Common Sense on Mutual Funds (John Wiley & Sons 2010). Put another way, fund ratings are an effective sales and marketing tool but not an effective research tool.

Similarly, a research piece by Advisor Perspectives analyzed fund ratings and arrived at a similar conclusion. “We concur that (mutual fund) ratings are not an effective forward-looking measure, but that is not how they are used in the industry,” states the report’s author Robert Huebscher. The report also suggested that mutual fund ratings should be renamed “Historical Performance Measures” or something similar. This would help investors to avoid confusing fund ratings as forward looking benchmarks of performance.

Instead of analyzing historical performance, fund investors should be paying attention to costs, tax-efficiency and making sure the funds they choose compliment their investment goals.

3) Implicit Faith in Fund Managers
Despite experiencing the worst stock market drop since the Great Depression in 2008 and a “lost decade” of subpar performance, surely mutual fund managers have helped their investors to get ahead, right?

After evaluating 2008’s bear market performance, Dalbar reported in its Quantitative Analysis of Investor Behavior that in 2008 stock fund investors lost 41.6% compared to the 37.7% loss for the S&P 500 Index. Why are these findings significant and what do they prove?

Since the S&P 500 (NYSEArca: SPY) is a fully invested index, with no cash or bonds, it theoretically should’ve underperformed compared to actively managed funds designed to beat it. But it didn’t. This contradicts one of the famous sales pitches given for buying actively managed funds that attempt to beat benchmarks like the S&P 500, which is that portfolio managers can protect their shareholders during a bear market by going into cash, whereas an index fund or index ETF cannot.

Instead of proving that, it proves something quite different.

The fact that stock fund investors performed worse than a fully invested benchmark like the S&P 500, shows 1) portfolio managers are ineffective market timers, 2) portfolio managers have done a good job of not protecting shareholder’s capital and 3) protection during bear markets from portfolio managers is largely a myth.

If you’re a mutual fund investor that believes your fund manager can protect you from the next big crisis or whatever, it’s probably time to re-think your blind faith.

4) Ignoring Taxes
People invest in mutual funds as if taxes don’t matter. And the results have been disastrous.

A 2009 Lipper study found that buy-and-hold investors with stock mutual funds in a taxable account surrendered between 1.13% to 2.13% of their annual returns over the past 10 years. If that doesn’t sound like a lot, just remember it does not include the additional burden of annual fund expenses, sales charges, and internal brokerage trading costs. Added up all together, the annualized performance drag could be anywhere from 3 to 6 percent.

Lipper states, “Fund families and their boards should place more importance on serving the taxable investor by stressing after-tax performance and by providing improved compensation packages rewarding tax efficient behavior at the fund level.”

Amen.