THE BLOG
03/08/2011 09:26 pm ET Updated May 25, 2011

Investors Continue to Buy Underperforming Funds

I have a cushy job for you. You will be the fund manager of a mutual fund. Its benchmark index is the S&P 500. All you have to do is beat that index and you will be handsomely rewarded.

How difficult can this be? There are only 500 stocks in the index. They are among the biggest and best known in the country. Apple, Bank of America, Colgate-Palmolive, DuPont. You get the drift. It's easy to research these companies. The amount of publicly available information is staggering. They are followed by the best and brightest analysts on Wall Street. These companies have regular conferences where they will update you on their performance and prospects. Just pick the outperformers from this limited group and overweight your mutual fund with them.

You are not competing with a human. The guidelines for maintaining the index are published on its web site. You can easily replicate the index. All you have to do is beat it and you will be a hero to millions of investors. Money will flow into your mutual fund. Your personal compensation will go through the roof. How does "stock guru" sound to you?

Standard & Poors issues regular reports where it compares the returns of actively managed fund managers to their benchmarked indexes. Its most recent report is for the year-end 2010.

The report is corrected for survivorship bias, which means it takes into account those funds that are no longer in business. Typically, funds go out of business due to poor performance. Most studies ignore those funds, which distorts the results. In the past three years, seventeen percent of domestic equity funds merged or liquidated.

For 2010, almost two-thirds of large-cap, actively managed funds, that used the S&P 500 as its benchmark, were outperformed by the index. This is fairly consistent with prior years. In almost every other category, a majority of actively managed funds underperformed their benchmark.

When the assets of the funds measured are considered, the record for actively managers is better, with a majority outperforming their benchmark index.

The results are worse for bond funds. The majority of active managers failed to beat their benchmarks.

For investors, this report validates the view that chasing returns by trying to find outperforming actively managed funds is a fool's errand. The harsh reality is that most actively managed funds will underperform their designated index. Basing your selection on funds that outperformed in the past is ill-advised. There is no data indicating that past performance is indicative of future performance. To the contrary, there are many studies indicating that outperformance can be attributed to luck and not skill. Luck does not persist.

Don't expect to find the Standard & Poors survey, or the peer reviewed studies debunking the myth of fund manager skill, in the office of your local broker. Their interest is in keeping the dream of superior performance alive, through the use of costly actively managed funds.

It's all part of the grand plan to transfer your wealth to their pockets.

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