Are Your Mutual Funds in This Dismal 84% Majority?

It's hard to argue with the beauty of mutual funds. They offer instant diversification, spreading your money immediately across a host of stocks, bonds, and other investments. They spare you having to decide which holdings to buy and sell, and when to do so, as your money is instead managed by professionals for you. There's often a significant downside, though, and the folks at Standard & Poor's recently reminded us of it: Over the full year of 2011, about 84% of actively managed U.S. equity funds underperformed their relative S&P benchmark in 2011.

Got that? It means that the vast majority of managed stock funds (i.e., those where managers actively choose investments instead of passively tracking an existing stock index) focused on the United States didn't do as well as those index funds. You would have been better off just sticking with index funds.

On the contrary...
Of course, it's easy to quibble with that finding. It is, after all, just looking at performances over one year. Lots of great investments can have a bad year -- or several. One year never tells the whole story.

It's the same with mutual funds, which can be influenced by the stocks within them. In 2008, the market meltdown was driven by the credit crisis in the financial services industry, with the stocks of Bank of America (NYS: BAC) and Citigroup (NYS: C) , for example, cratering 60% and 73%, respectively. Plenty of mutual funds devoted sizable chunks of their assets to financial companies and suffered as a result. Even today, many stock funds that don't focus on a particular sector officially will still overconcentrate on some. Bruce Berkowitz's famed Fairholme Fund (FUND: FAIRX) , for instance, has a whopping 79% of its assets in financial companies.

So 84% of managed stock funds losing to index funds in 2011 isn't necessarily something to get worked up over... or is it?

The big picture
Well, the fact is, 2011 was not an exception for managed stock funds. It was just more of the same. We at The Motley Fool have been pointing out since the 1990s that the majority of managed funds underperform the market. Standard & Poor's latest data show that over the past three years and five years, about 56% and 61% of managed stock funds underperformed their benchmarks, respectively.

Here are some more findings:

• Most non-U.S.-managed stock funds also lost to their benchmarks over the past three and five years.

• Whether a fund focused on big or small companies, it still likely lost to the market: Over the past five years, 62% of all large-cap stock funds, 80% of all mid-cap stock funds, and 73% of all small-cap stock funds failed to beat their benchmarks.

• The pattern holds for bond funds, too, with benchmark indexes outperforming most bond fund categories over the past five years.

Curiosities and explanations
One particularly intriguing detail that the folks at Standard & Poor's pointed out is that active managers should have an edge in bear markets. After all, if the market heads south, a benchmark index that tracks the market has no choice but to head south, as well -- its holdings are predetermined and fixed. But a fund managed by a Wall Street professional has more choices. If its managers sense some looming trouble, or if they simply want to position themselves somewhat defensively, they could keep some of their assets in cash or in less volatile, more defensive holdings. But alas, "In the two true bear markets the [S&P] has tracked over the last decade, most active equity managers failed to beat their benchmarks."

So what's going on? Here are some explanations:

• Humans are imperfect, and fund managers are no exception. When a stock market bubble is forming, we can fail to see it, and even if we see it, we may want to grab a little more gain before getting out. We can be too optimistic, too confident, too... wrong, sometimes. Great fund managers have learned to keep emotions at bay, to stick to their convictions, and to be very rational.

• A key reason many funds underperform their benchmarks is simply their fees. A typical managed stock fund can sport an annual fee (its "expense ratio") of 1% and sometimes even 2%. Many index funds, meanwhile, charge less than 0.25%. Imagine a 10-year period over which both the market and a solid managed mutual fund average a 10% gain, pre-fee. If a whole-market index fund charges 0.20% in fees, it will post an average annual gain of 9.8%. If the managed fund charges 1%, its gain will be 9%. Over 10 years, a $10,000 investment will grow to about $25,500 in the index fund, but just $23,700 in the managed fund. That's a difference of roughly $1,800! Seemingly small fees can make a big difference.

What to do
Give this information, what should you do? Well, for starters, seek low fees when investing in managed funds, index funds, and even exchange-traded funds. Then, watch your managed funds. Expect them to outperform their benchmarks over the long term -- and be prepared to dump them if they don't. Or simply respect the odds and switch to one or more index funds now. Even super-investor Warren Buffett has recommended them for most investors.

There's no shame in earning an average market return -- especially when average is above average.

At the time thisarticle was published Longtime Fool contributor Selena Maranjian, whom you can follow on Twitter, owns shares of Fairholme, but she holds no other position in any company mentioned. Click here to see her holdings and a short bio. The Motley Fool owns shares of Citigroup and Bank of America. The Motley Fool has a disclosure policy.We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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