Mutual Fund Recommendations Are A Cruel Joke

Every day, in brokerage offices across America, stock brokers sit in plush offices and recommend actively managed mutual funds to their gullible clients. It’s both a cruel joke and a wealth transfer scheme. Here’s why.

Daunting odds

Brokers have lots of reasons they use to justify their mutual fund recommendations. They will often tout past performance, the Morningstar rating (”it’s a five star fund”), and the reputation of the fund manager or the fund family.

The universe of stock and bond funds is huge. At the end of 2015, according to an analysis prepared by Dimensional Fund Advisors (not publicly available), there were 4500 US-based stock and bond funds collectively managing about $6.6 trillion in assets. As you will see, picking an outperforming one makes finding a needle in a haystack child’s play.

Your broker is unlikely to tell you there’s an excellent chance the mutual fund recommended won’t even survive for 15 years, much less outperform its benchmark index. Only 43% of stock and bond funds survived the 15-year period ending December 31, 2015. Typically, funds go out of business due to poor performance.

What if you get lucky and your fund is one of the lucky survivors? Only 17% of stock funds, and a puny 7% of fixed income (bond) funds, survived and outperformed over the 15-year period measured.

If your broker disclosed this information, how likely is it you would rely on his or her mutual fund recommendation.

Lack of persistence

Most investors are familiar with the required disclosure that past performance is no guarantee of future results. Yet brokers often tout past performance and convey the impression it’s likely to persist. It isn’t.

Past “winners” are more likely to underperform than outperform in the future. Only about a third of stock funds, and 51 percent of the bond funds with good 5 and 10-year track records, beat their benchmarks in the subsequent five-year period ending December 31, 2015.

Impact of costs

Brokers typically recommend actively managed funds with management fees significantly higher than comparable index funds. They don’t tell you that this cost differential makes outperformance extremely difficult. Over the 15-year period measured, 26% of the lower-cost stock funds outperformed, compared to only 7% of the higher-cost funds. Bond funds had a similar result, with 10% of the lower cost funds outperforming and only 1% of the higher cost funds outperforming.

What if your broker told you this: The fund I’m recommending has a high expense ratio (management fee), which reduces the already small statistical likelihood it will outperform a comparable, lower cost index fund. Would you still follow his recommendation? Of course not.

John Bogle was right when he said: In investing, you get what you don’t pay for.

Summary of a wealth transfer scheme

Outperforming actively managed funds (or even those likely to survive over long periods of time) are in the minority. The past performance of a “hot” mutual fund is unlikely to persist. The high costs and excessive trading of actively managed funds makes it statistically unlikely the recommended fund will be a winner.

Of course, you could get lucky and pick a mutual fund “winner”, but relying on your broker’s recommendation of an actively managed fund is not an intelligent or responsible way to invest. It’s an excellent way to transfer your money into your broker’s pocket.

If you would like to share an investing experience with Dan, send him an e-mail at: dansolin@yahoo.com. If he uses it in a blog, he will send you an autographed copy of The Smartest Sales Book You’ll Ever Read.

The views of the author are his alone. He is not affiliated with any broker, fund manager or advisory firm.

Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

Get Dan’s investing insights by signing up for his free, weekly newsletter here.

Follow Dan Solin on Twitter: www.twitter.com/DanSolin