2 Things You Need to Know About Mutual Funds

So you don't have the time or the interest to pick stocks on your own. No problem -- most people don't. And congratulations for being honest with yourself.

You've chosen instead to put your money into mutual funds, letting an experienced money manager do the dirty work for you.

Is that a wise move? Here are two important things to keep in mind.

1. Fees can devastate long-term returns
You've probably heard that most mutual fund managers fail to even match the performance of a benchmark like the S&P 500. If you haven't, here's the deal: According to Standard & Poor's, two-thirds of actively managed stock funds have underperformed the S&P 500 over the last three years. About the same portion have failed over 10-, 15-, and 20-year periods. Out of more than 7,000 mutual funds, eight have bested the S&P 500 every year for the past decade. Seriously. Eight.

That's the single most important statistic you need to know when thinking about mutual funds, since any investor can buy an S&P 500 index fund and mimic the benchmark.

It's also important to know why so many mutual funds fail to beat the index. There are many reasons, to be sure, not least of which is that so many managers just aren't good at what they do.

But fees are one of the biggest reasons the mutual industry fails to perform.

Investment management is a difficult business. If a money manager can finish a career beating the S&P 500 by a percentage point or two per year, they'll have a statue built for them. Think about this: Bill Miller of Legg Mason is almost universally known as one of the greatest mutual fund managers of all time. How did he do? From 1991 through 2011, his Legg Mason Value Trust turned $10,000 into $63,000, according to Morningstar. Investing in the S&P 500 over that period turned $10,000 into $59,000. Annualized, that's 9.1% vs. 8.8% a year, respectively. Almost indistinguishable.

And he's a legend, remember -- a one-in-ten-thousand, literally.

Miller's an incredibly smart guy. He made some bad bets during the last few years, but he's still a great investor. What really crushed his long-term results were management fees. The Value Trust's 1.77% annual fee set a high hurdle to beat every year before the fund even caught up the benchmark.

If you want to see how fast fees take away from long-term returns, check out this Vanguard calculator. Take a mutual fund that matches the performance of the S&P 500 (a top-tier fund these days), but charges a management fee of 1% more than an index fund. With an investment of $10,000, by the end of 25 years the index fund investor will have $13,000 more than the mutual fund investor. That's the kind of thing that should give long-term investors the shivers.

2. You're not off the hook
The allure of mutual funds is that it supposedly lets investors off the hook, giving someone else the responsibility of managing your money.

But that's not the whole story. No matter what fund you invest in, the most important decisions are still made by you.

One study by Dalbar showed that the S&P 500 returned 9.14% a year over a 20-year period ended 2010, but the average investor earned 3.83% a year. Why? Mainly because they bought and sold at the wrong times -- getting into the market just as stocks were expensive, and bailing out just as they got cheap.

It's the same for mutual fund investors. Another study found that mutual fund investors earned an actual annual return of 1.6% below their funds' stated performance from 1991 to 2004 due to buying high and selling low.

Even the best investors in the world get bucked around by the ups and downs of the market. If you fall victim to the emotions of those ups and downs, your investments will do poorly no matter what "legendary" fund manager you put your money with. Buying and selling at the wrong time means it's possible to invest with a talented fund manager who earns great returns and still lose a lot of money. Indeed, that seems to be the norm.

So what do you do now?
There are some very good mutual funds that are worth their fees and worth your money. They exist. There's no reason to detail them here because that isn't the point of this article.

This is the point: For passive investors who don't want to spend time following markets or picking winners, there are better, safer, options that will help you build wealth over time: index funds.

Take an index fund like Vanguard's Total Stock Market (NYS: VTI) ETF and related mutual fund.

The Total Stock Market Index owns a tiny bit of just about everything -- 3,313 companies, to be exact. The fund's distribution is fairly dispersed, but still weighted toward the largest names, with the top five holdings -- ExxonMobil (NYS: XOM) , Apple (NAS: AAPL) , IBM (NYS: IBM) , Microsoft (NAS: MSFT) , and Chevron -- making up about 10% of the fund. That means it has participated in the tech boom that has lifted Apple and IBM so high -- even if it largely left Microsoft behind -- as well as the big energy rush that has reawakened domestic oil and gas production and helped boost Chevron and Exxon in the process. Yet its goal is not to beat the market; it is to be the market while charging the absolute lowest management fees.

The rationale is simple. The total return earned by equity investors in aggregate in any given year is whatever the market generates, minus management fees and transaction costs. Vanguard founder John Bogle calls this "the relentless rule of humble arithmetic." It goes like this:

  • Over half of all investors must underperform the market average, since fees subtract from the aggregate market return.
  • Thus, you can do a little bit better than the average investor by being the market average and keeping your fees as low as possible.                                                                                                               

Being a hair above average isn't half bad, either. Since 1993, the Total Stock Market Index has produced an average annual return of 7.5% per year.

Of course, investing in index funds can be futile if you fall for the same trap of buying high and selling low described above.

There is, however, an easy fix: dollar-cost averaging, or purchasing an equal dollar amount of stock every month or every quarter, come rain or shine, bull market or bear.

Dollar-cost averaging in a broad index fund doesn't guarantee you'll make money over time. It doesn't guarantee a comfortable retirement, college for your kids, or a spot on the Forbes list of billionaires. But it guarantees that you'll own a slice of the global economy, purchased at an average price that is impervious to market volatility, and with a rock-bottom management fee. It also guarantees -- a mathematical certainty, in fact -- that you will do better than a slight majority of investors over time. That's the beauty of indexing -- and something you're not likely to achieve with mutual funds.

At the time this article was published Fool contributorMorgan Houselowns shares of VTI, Exxon, Microsoft, and Chevron. Follow him on Twitter @TMFHousel.The Motley Fool owns shares of International Business Machines and Microsoft. The Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of Apple, ExxonMobil, Chevron, and Microsoft, as well as creating bull call spread positions in Apple and Microsoft. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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