In the U.S., the Standard & Poor’s 500 stock index (S&P 500) is up 12.6% year to date 2012.

That is the good news. The bad?

Your mutual fund is likely not meeting or exceeding this benchmark.

Why the underperformance against investment benchmarks? 

The Facts

From The Wall Street Journal’s, “It’s Not Your Fault Your Fund Can’t Keep Up”:

A Morningstar survey for The Wall Street Journal Sunday found that only eight of the 25 largest actively managed funds—all types, from bond funds to foreign—beat the S&P 500 for the quarter.

That’s right in line with previous analyses. On average, fully two-thirds of mutual funds lag behind their respective benchmarks, according to Morningstar. (Such studies stacked bond funds against bond indices; and stock funds were compared to stock indices.)

And over the long haul, according to fund guru John C. Bogle, virtually all fail.

If you own a mutual fund, there is a strong probability that it will underperform its relevant benchmark. There are a few reasons why.

Individual Asset Selection Is Not Easy

Part of the problem is that active mutual fund managers historically, and on average, do not beat the markets with their picks.

Timing market movements and/or identifying the best individual assets is not simple. Even the professionals get it wrong a fair amount of time.

Larger Funds Become the Market

Even if the asset manager is a great individual asset selector, the larger the fund becomes, the less impact an individual selection makes on the overall portfolio.

The linked article mentions a few large funds: USD 59 billion large-cap American Funds Investment Co. of America Fund (AIVSX); USD 54 billion American Funds Washington Mutual (AWSHX); USD 37 billion Vanguard Windsor II fund (VWNFX).

At those sizes, even if they find the next great company, how much can they add to their portfolios? There are limits as to what one can buy.

Large funds need to buy large companies. Investing in a small company will result in too few shares to have any overall portfolio impact. Or buying too many shares and running afoul of securities regulations in regard to ownership levels.

If stuck investing in large cap companies, large funds essentially become the market themselves. An advantage of small funds – and often a reason why funds are capped – is being nimble.

Consider AIVSX. 4.45% of AIVSX’s total fund holdings is Philip Morris (PM) stock as at December 31, 2011. So AIVSX owned about USD 2.63 billion of PM, which itself has a market cap of around USD 150 billion. AISVX could probably invest a few billion more without getting into problems. But that is because PM is a very large company. The same is true for their other big holdings – Microsoft, AT&T, Dow Chemical, Royal Dutch, Apple.

But are these stocks not simply the equity market itself?

What about investing in the best performing stocks of 2011?

According to The Street, the five best-performing S&P 500 stocks in 2011 were: Cabot Oil & Gas (COG); El Paso Corp. (EP); Intuitive Surgical (ISRG); Biogen Idec (BIIB); Mastercard (MA). The April 9, 2012 market caps of each were: COG, USD 6.5 billion; EP, USD 23 .2 billion; ISRG, USD 21.7 billion; BIIB, USD 30.0 billion; MA, USD 55.0 billion. With the possible exception of Mastercard, it would be difficult for AIVSX to acquire enough shares of these companies to have any real impact on the fund performance.

Fees Hurt Net Performance

I write about this a lot. Fees may be the biggest reason for underperformance.

You own a fund that beats its benchmark by 1%. Pretty good. Until you realize that you are paying a 2% management or total expense ratio each year.

You want to improve your performance, focus on fund fees. Stick with passively managed open ended index and exchange traded funds (ETF) to minimize costs.

For example, AIVSX has an annual expense ratio of 0.61%. Not bad for a mutual fund. Its top 10 holdings at December 31, 2011 were Philip Morris, Microsoft, AT&T, Dow Chemical, Royal Dutch, Apple, ConocoPhillips, Home Depot, Abbott Laboratories, JP Morgan. These stocks make up 27% of the fund, so a big impact on overall performance.

Yet consider the iShares Russell Top 200 Index Fund. Its top 10 holdings include Apple, Microsoft, AT&T, and JP Morgan. Significant overlap with AIVSX.

And the iShares ETF only charges 0.15%. Almost half a percent less than AIVSX.

Oh yeah, it is up 12.8% to March 31, 2012, versus AIVSX at 11%.

What to Do

The article provides some good advice for investors:

investors should look for funds with low expenses and pick fund managers with long, consistent track records of success. They should avoid newly established funds, or those with relatively inexperienced managers. Then, look for funds without wild year-to-year swings in investment return.

As I elaborate in Why Active Investing is not Optimal, avoid the expensive active management approach. The payoff is usually not worth the price. Keep costs low and try to match the market as best you can. That means passively managed open ended index mutual and ETFs.

If you do consider active management, look at long-term fund management performance.

You want to see how the manager does over time and in both up and down markets. Remember that a fund may be in place for a long time, but management can change. What a prior manager did 5 years ago may not be relevant to what the current manager will do tomorrow. So study the manager and not simply the fund.

Next time I will have a few words on the last part of linked The Wall Street Journal article. Namely that you face a formidable investing foe: yourself.

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