Imagine you’ve just stepped into a casino. It has only two games. Both have big stakes – your retirement.
One game offers a crowd of players who come, play and fold. It’s an exciting game. The odds are deeply stacked against winning, but winners make it big. There’s about a 5 percent chance that you’ll come out a big winner.
And there’s about a 15 percent chance you’ll do as well as playing the other game.
The other game is kind of boring. It’s never dramatic. But you know that if you stay, you’ll beat about 85 percent of all the other players.
Which do you choose? (Remember, your retirement is at stake.)
That’s a situation that Kiplinger’s, one of the big and often useful personal finance magazines, doesn’t tell you about in one of its regular features. It invites you to the mutual fund casino. It rings a bell and names the big winners. It shows you how high the winners’ returns were compared to the much lower figure for the average player.
Boy, those winning funds look good!
How to promote mutual fund gambling
Wait a minute, you say.
Are you trying to tell me that Kiplinger’s is promoting casino gambling?
Not at all. They’re quietly promoting mutual fund gambling.
Allow me to explain.
Hot performance figures
Kiplinger’s has a regular feature on mutual fund performance. It seems to tell us a lot about the top funds in 11 mutual fund categories. Better still, it tells us the winners in those categories over time periods from one to 10 years.
The March issue deals with performance for periods ending last December. It tells us, for instance, that if we had wanted to invest in large company stocks and had chosen Morgan Stanley Insight A shares 10 years ago, we would have enjoyed a compound annual return of 23.1 percent.
That’s impressive.
Even if we looked at the bottom fund on their list of 10, Fidelity OTC fund, it would have provided a 19.5 percent annualized return.
Double your money in half the time!
Trust me, you should be impressed. The average fund in that category provided an annualized return of 12.5 percent.
That’s a lot less. At the category average return, your money doubled about every six years. With the winners, it doubled about every three years.
Big difference.
The feature seems like a great public service. You see how the best funds in 11 categories performed. You get their names. And you see how they compare with the average in their category.
So why do I find it profoundly annoying?
Give up?
The past isn’t the future
Here’s why: It’s a big display of misleadingly specific data. While it excites our hunger for big winnings, it has no redeeming investment value. Their list of funds performs the same function as the bell that goes off in a casino when someone makes a lucky pull at the slot machines: It furthers hope in a game with poor odds.
Whether you are investing over one year or 10, having a list of top funds for that particular time is just a bell. It has no value for what we are interested in.
That’s future returns. Not past returns.
Here are some of the facts that Kiplinger’s doesn’t tell you. Without them, you have no idea of what the odds are in your personal fund picking game.
You had to pick from a lot of funds.
Using the Morningstar database, Kiplinger’s provides performance figures on top 10 funds in each of 11 categories. They do this for four time periods: one-, three-, five- and 10 years.
So, lots of funds are listed.
The funds have typically been in the top 10 percent, or better, of their category for the time period. The problem is that those winners weren’t obvious when the investment was made. Basically, it was no better than a one-in-10 shot.
Actually, the selection was far harder than that.
Morningstar reports on, and ranks, funds that survive the given investment period. Mutual fund closings (and ETF closings) are regular events. According to the most recent Standard & Poor’s Index Versus Active (SPIVA) report, the death rate for mutual funds remains high. It ranged from 5 to 10 percent across all categories in 2020.
But wait, it gets worse.
Some 96 percent of all large company funds that started 2020 survived the year. Only 87 percent of those started three years ago survived, only 77 percent of the five-year funds, only 63 percent of the 10-year funds and only 27 percent of the 20-year funds.
It turns out mutual funds are a bit like pets. Odds are, you will outlive them.
So, while the lowest performing fund in a Kiplinger’s list of 10 might be in the top 5 percent of surviving funds over the last 10 years, you were really choosing from a group that was much larger when you made your investment. That means the odds of picking a winner were worse.
The most certain way to beat the average performance for any category is to index.
While Kiplinger’s provides the average performance in each time period for the chosen categories, the magazine neglects to mention the return of an index fund for the same category. Since most funds fail to beat their index, the odds are that an index fund will beat the category average by a healthy amount.
The longer the investment period, the smaller the portion of managed funds that beat the index they are measured against.
While 60 percent of surviving large company domestic funds failed to beat their index over the last year, the fail rate reached 82 percent by 10 years.
It hit an amazing 94 percent by 20 years.
The SPIVA report shows similar failure rates for international stock funds, emerging markets stock funds, and fixed-income funds. After 10 or 15 years, there’s about an 85 percent probability that a managed fund will fail to beat its index. That means that you, as an index investor, are likely to beat about 85 percent of all managed funds.
Investing, like life, is a game of bets and chance. We never know enough to be certain. We make the best decision we can, based on the facts we know.
Related columns:
Scott Burns, “The best and worst of Texas public pension managers,” 8/15/2020 https://scottburns.com/the-best-and-worst-of-texas-public-pension-managers/
Scott Burns, “Two days of truth in 365 days of snake oil,” 4/17/2020 https://scottburns.com/two-days-of-truth-in-365-days-of-snake-oil/
Scott Burns, “SPIVA, again and again and again,” 11/29/2019 https://scottburns.com/spiva-again-and-again-and-again/
Scott Burns, “The simplicity manifesto,” 3/31/2019 https://scottburns.com/the-simplicity-manifesto/
Scott Burns, “Index Investing –it’s way more than a gentleman’s c,” 9/28/2018 https://scottburns.com/index-investing-its-way-more-than-a-gentlemans-c/
Scott Burns, archived columns mentioning SPIVA back to 2006 https://scottburns.com/?s=SPIVA
Sources and References:
Berlina Liu and Gaurav Sinha, “SPIVA U.S. Year-End 2020,” 3/11/2021 https://www.spglobal.com/spdji/en/spiva/article/spiva-us/?utm_source=marketo&utm_medium=email&utm_campaign=email_campaign&utm_content=spiva_us&mkt_tok=ODM4LUxEUC00ODMAAAF7wPqihXukrDcSS4Vg_OQp2J3g_mrpeSNp1w0KGGpamZsrDzsn-GiV8T83kO2ssluaD_ZSCawNrZF6Tdw_OrwOxng_pQB1wmjkpremg0c
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
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(c) Scott Burns, 2021