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Your Mutual Funds (Still) Suck

S&P released the 2014 SPIVA analysis over the weekend and the results were not so pretty. They found that mutual funds and “active” funds regularly underperform their benchmarks:

“Based on data as of Dec. 31, 2014, 86.44% of large-cap fund managers underperformed the benchmark over a one-year period. This figure is equally unfavorable when viewed over longer-term investment horizons. Over 5- and 10-year periods, respectively, 88.65% and 82.07% of large-cap managers failed to deliver incremental returns over the benchmark.”

This is not remotely shocking. I’ve been highlighting these reports pretty much since the day I started this website. We have to always remember the arithmetic of asset allocation when analyzing performance. That is, in the aggregate, we all generate performance that makes up “the market”. But as asset allocators with inherent frictions (costs, taxes, etc) we also can’t perfectly replicate “the market” because the market is a pre-fee and pre-tax benchmark. So the aggregate return of all asset allocators must be the aggregate return MINUS frictions. That is, in the aggregate, WE ALL UNDERPERFORM “the market”.

To apply some figures to this, think of it like this. A balanced 50/50 stock/bond portfolio has generated about 9% compound growth over the last 50 years. The average mutual fund charges about 0.75% and the average advisor charges about 1%. So, take your 9% and subtract 1.75%. Then send Uncle Same a check for 20% and then account for the average rate of inflation of 3%. Your real, real return then comes out to about 2.5%. Of course, you can’t control all of this, but you can control big chunks of it. You can cut that 1.75% management fee down tremendously. And you can control the taxes you pay by taking a somewhat long-term view (but, of course, not taking an unrealistic “long-term” view).

Most fund managers sell investors a pipe dream about “beating the market”. The reason they sell this pipe dream is because they want to charge a high fee for managing your assets. And in doing so they often incur short-term capital gains that further compound the problem. Thankfully, people are increasingly catching on to the ridiculous notion of paying huge sums of money to people to try to deliver something that they simply can’t achieve over long periods of time. But it seems to be taking longer than we might expect.

The worst part is, most of us don’t even need to “beat the market”. If you think of your portfolio as your “savings” then most people would be perfectly fine just beating inflation by a decent amount and doing so without taking huge amounts of permanent loss risk. Instead, we pay huge sums in taxes and fees to try to achieve something that is incredibly difficult just because we’re greedy. In reality, we should be maximizing our primary source of income and treating out savings like it’s ACTUALLY our savings (instead of some get-rich-quick stock market scheme).

Of course, we’re all active in that we have to choose asset allocations and manage that portfolio over time (the idea of passive indexing is often misleading). You can’t control the return that portfolio will generate. But that doesn’t mean you have no control over your portfolio’s total return. And the best way to guarantee higher returns is to reduce fees and taxes. So get to it.