Mutual Funds: Do They Really Make Us Money?
Updated: May 7, 2020
Source: (TMF, 2020)
Since the launch of the first Mutual Fund in 1963, the rate of investment into these assets has grown sixty-fold.
The popularity of such funds can be connected to the fact that they satisfy two key needs of the investing population: the desire to grow one’s wealth and the comfort of relying on an experienced finance professional.
A seemingly perfect product for the modern-day profit seeker.
Salient as they may seem from the outside, exploring the numbers behind mutual funds reveal that they may not be as profitable as we initially thought. Here’s why.
1. Most Fund Managers Underperform The Market
According to multiple research projects, almost 80% of fund managers are unable to beat the market (i.e. the S&P500 index) over a 5-year period, and over 92% underperform the market over a 15-year period.
This means that while most fund managers may make a profit, they are unable to match how much the S&P500 index grows in a given period.
The average mutual fund - being actively managed by finance professionals - made only 17.08% in 2019, while the S&P500 returned 29.70% instead. - The Balance
Such a disparity between the S&P500 index (an automated fund that tracks the US market, one that anyone can invest in) and an active manager's services evidently points to one question: what is the actual value being added by a mutual fund manager?
With the development of online investing, people seeking lucrative opportunities can benefit enormously from simply - and individually - putting their money into the S&P500 index and matching the market’s return (29.70% last year) from home. If achieving such returns from home and by oneself is a possibility, the professional fund manager's services - one of the key selling points of a mutual fund - is perhaps not as valuable as we may have initially thought.
Undoubtedly, there are still some exceptional mutual fund managers that boast a history of beating the market... but that comes at a cost. A rather large cost, outlined below.
2. The Role of Fees.
While we may believe that reputable mutual fund managers are the key to earning passive income, exploring the role of fees quickly dwindles this initial optimism.
According to The Motley Fool researchers, the average expense ratio (fee percentage) in a mutual fund is 3.17%, whereas the average fees in an index fund is only 0.14%.
The asymmetry between the fees above may not seem too drastic at face value, but they create a notable difference when money is compounded over time.
Figure 1: Effect of Fees over a 30-year period
Source: (Robbins Research International, 2015)
Above, we experience a situation where two neighbors put in the same $5500 in a fund each year and yielded the same 18% return, only the left individual invests in a popular (but expensive) mutual fund and the right one puts his money into a low-cost index fund (such as the S&P500).
By the end of the investment period, we clearly see that the mutual-fund investor is left with less than half of his index-fund-loving counterpart.
Identical investment, return, and timeframe…yet substantially different outcomes.
This disproportion shown above implies that, even though a minority of fund managers make a profit, the iniquity of fees can slowly chew away at such returns over time.
So what are better alternatives to Mutual Funds?
Clearly, mutual funds are not the utopian stairway to wealth that we once thought they were. Instead, consider three more profitable alternatives below, all of which investors can pursue individually:
1. Low-cost Index Funds: Mentioned throughout this article, the favorability of index funds are prime. Index funds are a compilation of stocks/companies that automatically track the performance of specific indexes such as the S&P500, DJ30, and NASDAQ100. Investing in these allows the population to match the stock market’s returns without incurring high fees.
2. Gold: Ray Dalio – one of the world’s most successful investors – currently predicts that Gold prices may rise up to 30% in the near future. The reduction of interest rates and more political conflicts points towards higher demand for safe assets, which is why gradually investing in Gold could be far more beneficial than mutual funds.
3. Blue-Chip Stocks: On the slightly riskier side, retail investors could invest in Blue Chips: which are established, reliable companies with a strong financial background. Diversifying BC purchases across sectors (buying several blue-chips in telecom, technology, entertainment etc.) will allow individuals to reduce their risk whilst still gaining a steady stream of returns. This almost reflects the process of mutual fund investments, except that it can be independently done and done so without the revile fee charges.
Whenever in doubt over the merits of mutual funds, consider the fact that no mutual fund ever created a millionaire, but independent investing has, does, and will likely keep doing so for the foreseeable future.