Why Mutual Funds Underperform the Market

| November 03, 2023

Either you or your neighbor will be interested in this column, because about half the households in the U.S. had investments in mutual funds last year. That’s up significantly from the past few years, when the percentage was in the mid-40s.If you own any mutual funds, are they actively managed? That is, are managers researching securities, selecting what they believe the best choices are for the fund while selling current positions? If you do own actively managed funds, chances are they’ve underperformed the market over the long term. Standard & Poor’s reports that less than one in eight large-cap funds (ones that invest in the largest companies) did better than the S&P 500 for the past five years. The percentage increases for one and three years, but the results are still less than impressive. The S&P report jibes with many other research reports over the years. So what’s holding back performance of actively managed mutual funds?

High management fees are a major factor. You have management fees, administrative expenses, and 12b-1 marketing fees, for a start. They might seem small at first, but over time they’ll eat away at your return and can eventually create a significant drag on performance. Then there are costs that are harder to spot. One of the biggest ones is the transaction cost incurred when a manager trades positions in the fund. Remember, you’re an owner of the fund, so you share in paying the costs. And when you have a mutual fund that makes a lot of trades, your costs go up.

Another aspect is that managers face the same challenges Main Street investors do in gauging market movements and keeping investing biases at bay. They’re prone to herd mentality rather than making completely independent decisions. They might be able to understand current market conditions and handle the emotions of investing better than you do, but that doesn’t mean any of this is easy for anyone.

The mutual fund industry measures performance against benchmark indexes, giving rise to a third problem. Managers often play not to lose instead of beating benchmarks by employing conservative investment strategies. To use a football analogy, how many times have we watched our favorite team lose because it went to a prevent defense instead of doing what made them successful earlier? Fourth, mutual fund managers often have investment mandates that restrict what they can do. when market conditions change. If you want to buy some small-company stocks because you believe their investment potential is better than that of large-company stocks, you can do that. But the manager of a large-cap fund might not be able to.

These are just some of the barriers to better performance for mutual funds. There are some good reasons for owning mutual funds but go in with your eyes open and work with your financial professional on selecting the best ones to pursue your goals.




Evan R. Guido is the Founder of Aksala Wealth Advisors LLC, a 2018 Forbes Next-Gen Advisors List Member, and Financial Professional at Avantax Investment ServicesSM. Evan heads a team of retirement transition strategists for clients who consider themselves the “Millionaire Next Door.” He can be reached at 941-500-5122 or eguido@aksalawealth.com.   Read more of his insights at https://finance.heraldtribune.com/category/ask-guido/. Securities offered through Avantax Investment ServicesSM, Member FINRA, SIPC.  Investment advisory services offered through Avantax Advisory ServicesSM, Insurance services offered through  an Avantax affiliated insurance agency.  6260 Lake Osprey Dr. Lakewood Ranch, FL 34240.  The views and opinions presented in this article are those of Evan R. Guido and not of Avantax Wealth Management® or its subsidiaries.  Past performance does not guarantee future results. The S&P 500 is an index of 500 major, large-cap U.S. corporations. Standard & Poor's is a corporation that rates stocks and corporate and municipal bonds according to risk profiles. The S&P 500 is an index of 500 major, large-cap U.S. corporations. You cannot invest directly in an index.  An investment in a money market fund is not insured or guaranteed by the FDIC or any other government agency.  Although the Fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the Fund.  CDs are FDIC insured and offer a fixed rate of return.  They do not necessarily protect against a rising cost of living.  The FDIC insurance on CDs applies in case of insolvency of the bank, but does not protect market value.  Other investments are not insured and their principal and yield may fluctuate with market conditions. Investments are subject to market risks including the potential loss of principal invested.