The study appeared in The Journal of Portfolio Management and is quoted in a fascinating new book about investment by David Swensen, the chief investment officer of Yale University. He has acquired near-legendary status in the US investment community for his successful management of the Yale endowment fund during the past 15 years.
The fund's returns have trounced nearly all its peers, in part through the pioneering use of so-called "alternative assets" (hedge funds, private equity and so on). To say Swensen has a poor opinion of the way that most mutual fund companies operate - and the detrimental effect that this has on the finances of the individual investors - is something of an understatement.
Coming from someone with a less impressive track record, his argument might be regarded as outrageous invective. In fact, his carefully assembled collection of facts and figures commands attention. On the question of mutual fund performance, Swensen is unambiguous. "The overwhelming number of mutual fund investors clearly suffer at the hands of the mutual fund industry," he says. "Some of the causes - outrageous fees, excessive trading and bloated assets - stand as obvious culprits in producing performance deficits. Other factors - unethical kickbacks and indefensible distribution practices - remain generally hidden from view."
The study looked at the performance of mutual funds (the equivalent of our unit trusts and Oeics) during the two decades to 1998. This, it may be worth recalling, was a period of phenomenal growth for the mutual fund business, during which the number of households owning mutual funds rose from just 6 per cent in 1980 to more than 50 per cent in the year 2000.
What the study by Rob Arnott, lead author, et al did was take a detailed look at the way the universe of actively managed fund performed during those years. Unlike many studies, this one allowed for survivorship bias and compared the performance of actively-managed funds with that of a real-life benchmark that investors could own, the Vanguard S&P 500 index fund, rather than some artificially constructed index.
The average mutual fund underperformed the market by 2.1 per cent a year during the full 20-year period. Over 15 years, the shortfall was 4.2 per cent a year and over 10 years, 3.5 per cent a year. If that was bad enough, the picture looks even worse when they calculated the odds that investors could pick one of the minority of funds that did outperform the Vanguard index fund.
The figures are worst for the 15-year period, as investors had only a one-in-20 chance of picking a winning fund, the study suggests. Over 10 years, the comparable figure was 14 per cent (about one-in-seven) and over 20 years, 22 per cent (around one-in-five). The average "margin of victory" - that is, the extent to which the average winning fund outperformed the Vanguard index fund - was between 1.1 per cent and 1.9 per cent a year, whereas the average margin of defeat was much higher.
If these odds were not bad enough, says Swensen, you also need to take into account the effect of taxes. In the US, most investors have their money in taxable accounts, meaning that the funds have to pay taxes on gains realised in the course of trading.
This should have acted as a deterrent to a high turnover of stocks within the funds, as every transaction increases the probability of incurring a tax bill. Yet, in practice, the managers of most actively managed funds continued to churn their portfolios at a rapid rate, increasing the tax burden on their funds and damaging the odds of the fund's investors beating the market yet further.
Both the odds of winning and the likely margin of outperformance, therefore, fall further still, with the 15-year figures again showing the worst odds.
As the performance shortfalls compound over time, the conclusion of Arnott is uncompromising. "Starting with an equal amount of money in 1984, 15 years later an investor in the average losing fund would have roughly half the wealth that would have been amassed had the money been invested in the Vanguard 500 Index Fund."
Presented this way, it is obvious that the ordinary investor has little chance of making those kind of odds pay. Backing a 10-1 shot to gain a 1 per cent a year advantage over a passively managed index fund alternative, while taking a 50-50 risk of underperforming by 3 to 4 per cent a year, is very poor business. Yet this is what many investors have been doing with active management.
Mutual funds know this full well, says Swensen, but are all too happy to take investors' money. The business, he argues, is riddled with conflicts of interest, and prone to shady business practices. The rational investor is one, he says, who knows his limitations and will act accordingly - opting for a range of passively managed funds instead - preferably ones run by not-for-profit organisations.
In the UK, of course, the same issues arise, but are complicated by the fact that few passively-managed funds for private investors are competitively priced, and there are few if any not-for-profit providers. The average index fund in the UK has a total expense ratio of 0.7 per cent a year, compared with the Vanguard fund's 0.08 to 0.14 per cent. Paradoxically, this makes actively-managed alternatives appear relatively more attractive.Reuse content