What’s the Point of Mutual Funds? According to Standard and Poor’s There Isn’t One

September 11, 2015 Updated: September 14, 2015

Leave it to the pros. That’s what mutual fund companies tell the layman when he wants to invest in the stock or bond market. After all they know better, right?

Right. However, they don’t know better than the benchmarks they are supposed to outperform, according to a recent study by Standard and Poors, the parent of the famous S&P 500 index.

For the period of June 30 2014 to June 30 2015, 65.34 percent of U.S. large cap equity portfolio managers underperformed the S&P 500, which was up 7.42 percent.

They did even worse over 5 and 10 years, when 80 percent of fund managers didn’t manage to beat the benchmark. The same is true for fixed income and municipal bond funds as well as international stock funds—a large majority of them underperform their benchmarks over different periods.

Why? Gordon Gekko from the 1987 movie “Wall Street” thought he knew the answer: “Ever wonder why fund managers can’t beat the S&P 500? Cause they’re sheep, and sheep get slaughtered,” he opined.

Maybe it’s just the opposite. Of course, you can’t accuse fund managers of being greedy, which Gekko would have said was good, but it has to do with the fees they charge for their management.

They are relatively modest, around 1.15 percent on average per year, but that amount alone is often enough to make the difference between being better than the index or not. On top, you have hidden trading fees (brokers usually charge funds 0.2 percent on stock trades, which is directly deducted from the fund’s assets), and market impact: this means the stock price goes up if the fund is buying in large quantities.

The S&P 500 doesn’t have these problems. It just exists in a computer database. S&P collects the prices of the stocks and calculates the index in a massive excel spreadsheet. No trading costs, no market impact, and no fees.

And it gets even better: By definition, companies that do poorly just get kicked out of the index (because their market cap declines) and strong companies on the rise get included, again at no cost, whereas the mutual funds have to turn over a good chunk of their portfolio to make the necessary changes.

So what can you do? Obviously investing in the S&P 500 spreadsheet, which doesn’t have all the costs won’t do any good, but there are lower cost alternatives.

John Clifton Bogle, former CEO of the Vanguard Group pioneered the concept of index trackers. They slash costs to the bone and just replicate the index. This will still cost you, but it will cost you much less than people charging more and failing to beat the index.

Over 10 years, Vanguard is the winner: “For the 10-year period ended June 30, 2015, 10 of 10 Vanguard money market funds, 48 of 52 Vanguard bond funds, 18 of 18 Vanguard balanced funds, and 110 of 121 Vanguard stock funds—for a total of 186 of 201 Vanguard funds—outperformed their Lipper peer-group averages”—without even trying.

An infographic about the hidden fees in 401ks. (Personal Capital)
An infographic showing the hidden fees in 401ks. (Personal Capital)