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3 reasons not to rely on mutual fund returns

Richard Morin

Update :
11
September
2017
Update :
September 11, 2017

Mutual fund companies are constantly marketing the talents of their star managers. We are consistently shown funds that - under the guidance of these stars - have achieved excellent returns. Year after year, you invest your savings in these funds in the hope of achieving superior returns. After all, these managers are not stars for nothing; they must be "talented". Yet your portfolio performance remains mediocre and nothing like what the marketing brochures and your financial advisor tell you it is.

Why is this?

This is an important issue because your financial goals - including your retirement - are at stake.

First, a small consolation: as poor as your returns are, they are comparable to the average for mutual fund investors. But that average is significantly lower than the returns posted by the mutual funds themselves. A study[1] published annually in the U.S. shows that holders of equity mutual funds have underperformed the S&P 500 by an average of 3.5% per year over the past 20 years. On the bond side, the results are even more disastrous as investors have made an annual return that is 4.8% lower than the bond market. So how can mutual funds have great results when those who invest in them have poor returns?

Period
Investor returns[2]
   
Equity FundsAllocation
allocation
Funds
Funds
Bond Funds
InflationS&P 500Barclays
Aggregate
Bond Index
30 years old3,661,650,592,6010,356,73
20 years old4,672,110,512,208,195,34
10 years old4,231,890,391,887,314,51
5 years6,923,280,101,5812,573,25
3 years8,853,81-1,761,0715,131,44
12 months-2,28-3,48-3,110,951,380,55

1. Mutual fund mergers and closures

Mutual fund companies regularly "reorganize" their funds, including merging funds with each other (or closing them altogether). These mergers - announced in rather discreet press releases - make it possible to "disappear" funds that have underperformed by merging them with funds that have performed well. Thus, the firm no longer has to display the performance of the "bad fund", since it no longer exists! They only publish the performance of the "good" fund and its star manager. Fund mergers and closures are commonplace in the industry: 42% of Canadian equity mutual funds have "disappeared" in the last 5 years[3].

2. Mutual fund of the month or how to buy high and sell low

Another common practice of which many investors are more or less willing victims is "mutual fund of the month". When high-dividend funds, for example, have performed very well over the past year, the entire industry - from mutual fund firms to investment advisors to the financial press - will tout the merits of this management approach and push investors toward these funds. The returns advertised by the mutual fund firms will be those of the funds. This is how the average investor buys into the top of the wave. Alas, as these firms themselves will tell you (in a very small footnote): "past performance is not indicative of future performance".

3. Past performance is not indicative of future performance

Now that we know how the mutual fund industry gets you to buy at the top of the wave, let's see how the stage is set for you to sell...at the bottom. All management styles and sectors go through cycles. They go through periods of outperformance followed by periods of underperformance, and "star managers" can't change that. During their periods of outperformance, funds that invest in these styles or sectors experience an influx of new investors that usually peaks...just before the trend reverses. Having bought the fund at the end of the cycle, most investors will experience the inevitable period of underperformance, often lasting several years, or until they are offered to sell it and invest in the next "mutual fund of the month"...

How can you improve your performance?

The sad truth is that the vast majority of mutual funds underperform market indices. Since you can't rely on past performance to identify funds that have a chance of performing well in the future, how can you make the right choices and improve your portfolio's performance? Simply by investing in a portfolio of low-cost indexed exchange-traded funds that ensures you'll reap the benefits of the market, including dividends. This will give you a return that is far above the average investor!

Archer Wealth Management

Archer Wealth Management offers an alternative to large financial institutions and mutual funds. We are independent financial advisors and use an index-based approach to structure a diversified, customized portfolio that minimizes risk, costs and your tax bill. Archer is registered with the Autorité des marchés financiers.

1] DALBAR's 22nd Annual Quantitative Analysis of Investor Behavior

[2] Id. As of December 31, 2015

3] S&P Global, SPIVA® Canada Scorecard, 2015