According to a study written up in the New York Times (subscription required) this week, it isn't lousy management's frequent trading that's responsible for the poor performance of mutual funds. Nope, it's the investors who redeem their shares and force the funds to sell even if they don't want to. The study found that "liquidity-motivated" trades perform poorly compared to trades based on fundamentals.
Mark Hulbert, the author of the piece, suggests that investing in closed-end funds may be a way to avoid this problem, because they generally don't face redemption. In an exchange-traded fund, an investor who wants to sell shares just sells them to another investor. It's just like how selling shares of McDonald's Corp. (NYSE:MCD) would have no impact on the operations of the company.
And yet there's still a problem: Regardless of what any study says, mutual funds simply cannot, on average, outperform passively managed indexes. It's a zero-sum game. Before expenses, the average fund's performance can only be average. After expenses, the average fund is considerably below average. The fact that ETFs are almost always passively managed (rebalanced/adjusted once a year generally) is a large contributor to their outperformance. The fact that they are immune to redemptions by panic-stricken shareholders at precisely the wrong time adds to their value.
The more I study it, the more obvious I think it becomes: ETFs are probably better than traditional mutual funds for most investors.
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Reader Comments (Page 1 of 1)
1-15-2007 @ 8:48PM
Lisa said...
I beg to differ: I think it's mostly the frenetic trading that occurs within mutual funds on the part of managers that eats away at yields. "Better" mutual fund companies now impose substantial short-term trading penalties on investors who move in and out of funds quickly.
Managers should be able to anticipate longer-term investor fund liquidations--it isn't exactly rocket science to conclude that an investor in a retirement plan WILL probably liquidate shares after he or she turns 60. It isn't rocket science to conclude that a 529 plan investor will liquidate shares when the beneficiary turns 18.
Prudent individual investors keep a portion of their investments in more liquid assets to meet shorter-term or upcoming needs. That portion is, or at least should be, determined by the amount and nature of those anticipated expenses. Mutual fund managers need to do the same.
While I keep part of my portfolio in mutual funds, I have no other real choice if I want to be invested in the stock market. I have a 403(b) and a 457 plan, and neither permit investment in individual stocks. I select the best of the funds available in each plan and use the rest of my investments to try and offset the limitations of those plans. My IRA and non-retirement accounts hold mostly stocks, and I've done spectacularly well in spite of fairly casual research prior to selecting a stock. I've done well by investing relatively conservatively, by using dollar cost averaging, and most importantly, by buying and HOLDING. I've got exactly two "dogs" in my portfolio which I hold on to because they continue to pay generous dividends, and because I anticipate needing the tax advantage of a capital loss in 2008.
As for my mutual fund holdings, they haven't done all that badly, either--just not as well as my own uninformed investments.
1-15-2007 @ 10:45PM
mark said...
ETF's are a much cheaper, viable product with multiple features that are far better than mutual funds. These next few years will see tthe load and no-load industry shrink dramaticlly and the ETF world grow substantially.
3-30-2007 @ 1:05PM
Dave Exner said...
Can someone tell me how DODGX can show their numbers on Wednesday at a close of 155.65 (loss for the day 1.22) then on Thursday they show the same close and loss and up until this moment have not made an adjustment. I am now getting figures on my holdings to ensure there was not a loss both days.
No wonder so many are putting their money in gold!