Mutual funds are sold to the public like lottery tickets. They’re promoted with fanfare and colorful marketing campaigns that emphasize the possibility of earning a high return. What people don’t see is the high probability of losing out because the performance of most mutual funds is below the market.
Possible and probable mean separate things. Understanding the probability for success and knowing what a fair payout is are critical when playing the lottery or selecting mutual funds.
Possibility is what your right brain thinks when you see a billboard advertising a $20 million Powerball jackpot. “Wouldn’t it be nice to have that money? Of course it would. Let’s buy a ticket!” Probability is the math going on the in the left brain. “The odds are terrible. Wait until the jackpot builds to $500 million before giving it a shot.” I chose $500 million because that is the level where Powerball odds actually come close to being a fair game, according to Forbes columnist William Baldwin.
Understanding odds and a fair payout are vital to prudent mutual fund selection. We have a choice as investors. We can either attempt to beat the markets using actively-managed mutual funds or earn market returns with index funds and select exchange-traded funds (ETFs). Let’s look at the costs, odds and payouts for both active funds and index products.
- Actively-managed mutual funds have high costs relative to index funds. According to Morningstar Principia, you can buy an index fund that tracks the U.S. stock market for less than 0.1 percent per year. Similar actively-managed funds cost on average 1.0 percent. The fee difference immediately puts actively-managed funds at a disadvantage.
- Standard & Poor’s reports that only 25 percent of actively-managed funds have beaten a diversified U.S. equity index fund pre-tax over the past 5-year period. The after-tax returns are worse. Active funds have high portfolio turnover and distribute more in taxable capital gains than comparable index funds.
- The extra return from the 25 percent winning funds is relatively low compared to the underperformance of the other 75 percent. The mean winning fund achieved returns that were about 0.9 percent higher than the index while the mean losing fund fell about 1.7 percent short. Details on this phenomenon are available in The Power of Passive Investing.
In summary, actively-managed funds that try to beat index funds have higher costs, a low probability for success, and the payout doesn’t justify the risk. Investors who buy actively-managed funds can’t be engaging their left brain to calculate probability. They must be focusing solely on the possibility of a high return. It’s like buying Powerball lottery tickets when the jackpot is only $20 million.
The investment industry will try to sell you mutual funds like lottery tickets, but you’ll have more success if you buy them like a prudent business person. Weigh the probability for return against the cost and payout. Certainly some active funds will beat index funds. That happens every year, although it’s not possible to know which ones will in advance. In the long run, probability favors an all index fund portfolio all of the time. That’s the winning ticket.