Mutual Funds – The Great American Rip-Off

2021 was a great year for growth stocks. SPDR S&P 500 ETF Trust SPY an ETF that tracks the performance of the S&P 500 index was up 33% but 98% of all growth managers failed to outperform that benchmark.  Take it out “long term” and 90% of all domestic equity funds underperformed the S&P Composite 1500 Index over the past 20 years.

The financial industry loves to talk about long-term investing, but what is long-term?  Well, according to the IRS, long-term is 12 months and 1 day.  Anything less than that is considered short-term from a tax perspective and taxed at your ordinary income tax rate.

Think about when the calendar turns a new year.  The investment community parades out all their strategists, analysts and economists with their predictions for the upcoming year.  Which stocks, growth or value, which sectors, technology or healthcare, are going to outperform over the next 12 months?  Where will the markets end the year, and what about interest rates?  Rarely have we seen in 36 years of experience predictions for the next five years, or decade, as to what they think will happen.  Why is that?  Maybe it’s because, if you actually follow their predictions, you’d realize just how wrong they are.  LCM Capital Management (LCMCM) likes to call them “annual guesses.”  The word “guesses” sounds unprofessional, but the reality is, that is what they are.  Do yourself a favor and stop paying attention to them.  They are no better at it than you or LCMCM.

The reason the industry does not believe in actual long-term investing is because it tends not to generate fees.  When money is in motion, it generates fees and fees are good for business but not always good for the investor or client, especially over the long-term.  Gene Hochachka, from Frontier Financial, recently published a report abstracting data from Morningstar looking at active mutual funds turnover.  Turnover is the percentage of a mutual fund’s holdings traded annually.  He looked at the data from 1991-2020, i.e., long-term.  The average annual turnover for US Large Cap funds was 73%.  To put this in perspective, 100% turnover means the portfolio is traded (turned over) completely in one year.  So, 73% is approximately three quarters of the portfolio turned over every year.  So why would they do this?  You would think it is to improve performance, right?  The manager is selling bad stocks and buying what they consider to be good stocks or selling ones that have gone up and buying the ones that have gone down.  Yet Mr. Hochachka found that, “any other relationships between turnover and returns are similarly not borne out consistently across the various categories over time. Over this [30-year] period, high turnover does not hurt fund performance. Nor, however, does it enhance performance.” So why do it then?  To quote Rod Tidwell from Jerry McGuire, “show me the money” because it’s all about the money, i.e. the fees.  Our industry thrives on them and needs them to support their yachting habits.

Someone once said, the only way to make a lot of money on Wall Street is to start a mutual fund.  Ever look at the Forbes 500 list of the wealthiest people in the world – you might be surprised to see how many hedge fund managers, money managers, and venture capitalists are on the list.  Why are their clients not on the list? 

S&P Dow Jones Indices just came out with their annual SPIVA Survey on the performance, or should we say underperformance, of active mutual fund managers versus their stated benchmark.  Like the Forbes 500 list, the facts might surprise you.

The reason the industry talks the long-term investing game, but doesn’t walk the walk, is because, according to the SPIVA report, of the funds that have been around for 10 years, 86% of them underperformed their benchmarks.  Not exactly something to be bragging about, wouldn’t you agree?

So if trading within your mutual fund does not help performance, what does?  Stock picking, market timing, risk adjusted returns?

You probably have heard the term “a stock pickers market” at some point in your investing career or if you are just starting, you will at some point.  It is especially true in volatile markets like we have in 2022 and definitely had in 2021. In 2021, according to the SPIVA report, it was a great year for growth stocks.  The S&P 500 Growth Index was up 33% but 98% of all growth managers failed to outperform that benchmark.  Take it out “long term” and 90% of all domestic equity funds underperformed the S&P Composite 1500 Index over the past 20 years.  As a result of these facts, mutual fund managers like to counter with a claim that on a risk-adjusted basis they will outperform.  Once again, this is simply not true.  According to the SPIVA report, 95% of these same managers underperformed their benchmark on a risk-adjusted basis over the same 20-year period – so much for that claim.

This dismal performance however does not take into account all fees and costs.  Yes, the performance figures from the report are adjusted to include fees but not the mutual fund loads, if any.  Yet what about the fees you are paying your advisor or broker?  What about the taxes you paid if your mutual funds are not held in an IRA type of account? (Please see Vanguard Target Date Lawsuit 2021.)  If you add these two components into the equation, LCM Capital Management would ask, now what’s the underperformance of the active mutual funds against their benchmark, 99%?  We can’t say for sure, but in our opinion, clearly the odds are stacked against you.

So why is this the case?  Academics have known for decades that active stock pickers underperform, according to an article from CNBC’s Bob Pasani where he references this SPIVA report.  Why is that?  There are many reasons, some of which are; too much trading (see portfolio turnover above), trying to time the market moves (market timing is impossible to do consistently over time), and the all-in mutual fund fees and related costs are too high.  Jack Bogle, the deceased founder of Vanguard once said, “Before costs, beating the market is a zero-sum game.  After costs, it is a loser’s game.”  “Fund performance comes and goes.  Costs go on forever.

We consider mutual funds to be the Great American Rip-off.

The view expressed reflects those of the authors as of the date of this commentary. Any such views are subject to change at any time based on market or other conditions, and LCM Capital Management (LCMCM) disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for LCMCM are based on numerous factors, may not be relied upon as an indication of trading intent on behalf of LCMCM. Thoughts about investing, the direction of the market, and individual securities are based on the author’s own analysis and are not representative of actual future performance. Investing involves risk including the possible loss of principal.