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Guaranteed Failure With Mutual Funds

Sixty Eight percent of US Large Cap Funds lagged the S&P 500 benchmark over the previous five year period, according to the mid-year 2012 Standard & Poors Indexes vs. Active Funds (SPIVA) Scorecard. This result is consistent with historical patterns and results for other market segments.

A 68% chance of underperforming means a 32% chance of outperforming. These are tough odds, but the entrepreneurial nature of many Americans encourages them to believe they can find a way to beat them. Unfortunately, the odds get even longer with a portfolio of funds.

Let’s assume that funds which outperform do so by an equal magnitude as the amount of underperformance by those lag. Historically, this is a very generous assumption.

If you own six funds, your chance of outperformance drops below 15%. With twenty funds, the odds fall well under 10%. Ok, we admit this is still too high to guarantee failure, but there is no rational reason anyone would want their money facing a headwind like this.

One of the biggest fallacies in investing is having confidence in a mutual fund manager because of a strong track record. Of the thousands of active managers, statistically, some of them simply have to outperform. This has nearly nothing to do with what will happen in the future. In fact, the opposite may be the case.

According to the December 2012 SPIVA “Persistence Study”:

  • Very few funds manage to consistently stay at the top. Of the 707 funds that were in the top quartile as of September 2010, only 10% were still in the top quartile at the end of September 2012.
  • Looking at longer-term performance, only 5.16% of large-cap funds, 3.21% of mid-cap funds and 5.10% of small-cap funds maintained a top-half performance over five consecutive 12-month periods. Random expectations would suggest a repeat rate of 6.25%.

You don’t hear much about the headwinds of mutual fund investing because financial companies are making a lot of money selling actively managed mutual funds. But the numbers don’t lie. If you own a bunch of mutual funds, we encourage you to reevaluate your strategy.

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