Thursday, January 17, 2008

The Illusion of Mutual Fund Returns

You’d think that the reported return on a mutual fund would give an accurate picture of how much money the fund’s investors made. A study by Bullard, Friesen, and Sapp released in December 2007 shows that this isn’t necessarily the case.

It turns out that a fund’s reported returns only apply to buy-and-hold investors who held the fund from the beginning to the end of the reporting period. But not all investors do this. Due to the timing of investor money flowing into and out of the fund, the actual returns seen by investors are often lower.

The study found that for one class of funds, investors underperformed the reported returns by 2.28% per year! These funds are like guys on online dating sites who say they like long walks on the beach and talking about their feelings, but turn out to be beer-swilling football watchers like all the rest.

Across all actively-managed funds, investor money underperformed the reported returns by an average of 1.7%. Over 25 years, this would build up to 35% less money in investors’ accounts. In contrast, according to the study’s authors, “investors in no-load index funds experience no performance gap at all, suggesting that the smartest money is finding its way into these funds.”

But, how could a mutual fund’s investors get less than the return reported by the fund? It seems like there must be some sort of conservation law that makes this impossible. The short answer is that funds tend to have higher returns when they are small and lower returns when they are big. See this post for more on why this happens.

So, a small number of investors are in a fund while it does well, then new investors flock in, and fund performance drops. In the end, the average investor gets worse returns than the buy-and-hold investor who held the fund for the whole reporting period.

This argues for being a buy-and-hold investor when it comes to actively-managed mutual funds instead of constantly switching to the new hot fund. This post shows that investors would have been even better off abandoning actively-managed funds entirely and investing in index funds.

Stay tuned for more interesting results from this study.

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