Tuesday, March 20, 2007

Why Many Mutual Funds Underperform

This is the first post in which I have addressed the mutual fund industry. I'm a fan of mutual funds; especially for typical investors that don't want to spend much time on their investments. But there are a few things to consider when determining which fund to place your money with. First, there is the common maxim that you pay up for quality, and you get what you pay for. This is true in many facets of life, but not so in the mutual fund world. Quite often the opposite is true. Let me take you through the typical cycle of a successful mutual fund.

To begin, a manager needs capital to work with. Once a fair amount is in place, he's chasing performance. Once a manager has a big year, or a couple of consistent years outperforming the market, the problems begin. The positive press circles, the manager becomes well-known, and you know what? Everyone wants in. Billions are thrown at him. Now he's in a predicament. He has to try and take all this new money and invest it with the same principles that made his previous returns. But he can't buy into the same positions as before, because they are all inflated. He can't buy into smaller companies because he moves the price too much and is regulated against doing so. So now, you have a manager that is forced into buying things he doesn't even want to buy anymore. He is forced to follow the trail of all big funds and buy the same companies: (Exxon (XOM), Citigroup (C), General Electric (GE)). Now you have a fund that basically moves right along with the broad markets, and is taking huge fees on either front or back end loads, and management fees.

So that fund manager with that great investment theory has now become one of the many. His old theories still work, but he can no longer use them efficiently enough to make you money.

So, I don't believe in paying up for a fund. There are a lot of great low-cost funds out there that beat the S&P 500. The Vanguard family of funds consistently do it. I'm also impressed with Dodge and Cox. Their main stock funds have been closed to new investors, but do nicely with their international fund. It performs well, and they have a great management approach, and charge much less than average.

So bigger isn't always better, and you don't always get what you pay for. Just keep your eye out when investing, and there are a lot of great funds out there.

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