3 Bad Reasons We Pay So Much For Mutual Funds

Every time the market makes a big turn, this happens: A bunch of money managers previously hailed as brilliant get caught betting the wrong way. This time it's hedge fund managers making "macro" bets. For example, the $13 billion fund run by Paul Tudor Jones is down 4.4%, according to the Wall Street Journal, while the general stock market is up 5.4% and bonds are up 3.4%.

Meanwhile, in the prosaic world of mutual funds available to you and me, the evidence is overwhelming that most managers can't beat the market. Over the past five years, according to S&P Dow Jones Indices, about 73% of blue chip stock funds trailed the S&P 500 index. You can buy a passive S&P 500-tracking index fund for almost nothing—as little as 0.05% of asset per year—and get roughly all of the market's return. Funds that instead use human being to pick stocks often charge 1% to 1.4%, for worse results.

In a post on his Pragmatic Capitalist blog, Cullen Roche wonders why people keep buying these funds that cost more and deliver less. His explanations sound right—you should read them—and boil down to people being poorly informed and too emotional about investing. Not everyone knows how hard it is to beat the market, and the ones who do are overconfident about their ability to do better.

But I'd like to propose a few more reasons people like active funds, which go beyond overoptimism. I'm not advocating for these active approaches. In each case, if this why you use active funds, I'll suggest an alternative way of coming at the problem.

1) Using an active fund as a de facto financial adviser.

Many if not most fund managers these days are "closet indexers," meaning they stick pretty close to a stock benchmark like the S&P 500, with just a few deviations they hope will goose performance enough to justify their fees. But there is a subset of managers with a broader mandate. They mix up U.S. stocks, foreign stocks, bonds and other assets. Some, like the popular T. Rowe Price and Fidelity "target-date" funds, shift among these assets according to a pre-set formula based on their investors planned age of retirement. Others move around based on their views about whether, say, U.S. stocks look expensive or cheap. But in either case, their investors may not really be coming to them for market-beating stock picks. They are using those funds to help find the right split among stocks and bonds.

In other words, these funds are stand-ins for the financial advisers who help people set up their portfolios. The advice isn't personal, but really good personal advice is hard to get if you don't already have a big portfolio.

The better alternative: Buy a target date fund that uses cheap index funds instead. Or an index-based "balanced fund" with about 60% in stocks and 40% in bonds. Even if that's not quite the optimal mix, the advantage of low fees is often more important. Or you can build your own cheap three fund portfolio using the index funds on the Money 50 recommended list.

If what you really want is a fund manager who knows when to get you out of stocks before they drop, well, the truth is neither fund managers nor advisers are likely to time these turns consistently well. Investors who want to preserve capital in bear markets are better off just dialing back their stock exposure as a matter of policy.

2) Going active to get a tilt.

Not everyone wants exactly the level of risk the stock market delivers. Investors willing to live with more volatility to get a higher return might, for example, want to add more small companies to their portfolio. Likewise, there is some evidence that a bias toward value stocks can deliver better returns over the long run. For a long time, buying an active mutual fund was really the simplest way for most people to get a slightly different mix of risk and return characteristics than the market offered.

Those days are over. You can buy an index-based exchange-traded fund to capture almost any slice of the market or stylistic tilt. I'm skeptical of whether most of these funds are worth the bother, but many are cheaper and more reliable than pure active funds.

3) That enterprising feeling.

I've been a convinced indexer for so long that sometimes I forget how cynical the approach can sound to the uninitiated. You're just tossing your money into the market and betting that on average it works out. Mutual fund managers, on the other hand, say they are scouring companies' "fundamentals,"and "kicking the tires," and "thinking of ourselves as owners of businesses." (Never mind that for many fund managers holding a stock for a year is what counts as a long-run strategy.) At first blush, this doesn't only sound like a smart way to make money... it sounds like the right thing to do. A way to be a good steward of wealth and to help build the American economy. I'm often struck by how people seem to admire Warren Buffett not only as a smart businessman with a rare stock picking ability, but as a kind of spirit guide. Not for nothing is his annual shareholder meeting called the Woodstock of Capitalism.

Roche has what I think is a deep insight that might make you think differently about this. The money you put into equities via your 401(k) or IRA isn't really "investing," just saving with more risk and an incrementally better expected return than bonds. That's because you aren't handing any funding to the company, but buying an old claim on it from someone else.

...the reality is that when you buy stocks or bonds on a secondary market you are allocating your savings into what was really someone else’s “investment” and it’s very likely that the easy money has already been made and these real “investors” are cashing out. Real investors build future production, make great products, provide superior services and only sell their majority interest in that production at a much later date (often on a stock exchange via an IPO).

Whether you buy an active fund or an index fund, you'll be at a pretty distant remove from the companies you indirectly own. On average, you won't have much chance of a big return, and some tire kicking here and there won't add a lot of value. There's nothing wrong with that. Most of us don't have the time or the interest to be even part-time entrepreneurs. There's no shame—and a lot of gain to be had—in keeping it cheap and simple and moving on.