The overwhelming advantage of a mutual fund is diversification. The benefits of diversification include the following:
- It minimizes the risk of loss to your overall portfolio. (Risk is defined by the standard deviation of the returns of your portfolio).
- It exposes you to more opportunities for return.
- It safeguards you against adverse market cycles.
- It reduces volatility in your portfolio.
In A Random Walk Down Wall Street, author Burton Malkiel, explains these benefits:
By the time the portfolio contains close to 20 [similarly weighted] and well-diversified issues, the total risk (standard deviation of returns) of the portfolio is reduced by 70 percent. Further increase in the number of holdings does not produce any significant further risk reduction (2019).
Other investment advisors agree, saying that 20 to 30 stocks is good diversification. However, here’s the rub: one share of Amazon on August 19, 2020, cost $3,284, and one share of Google on the same day costs $1,561. Meanwhile, Facebook costs $271 per share, and Netflix costs $486 per share. (Along with Apple, these are known as the “FAANG” stocks). For us mere mortals who are not billionaires, how can we diversify into 20 or more stocks? The answer is, of course, a mutual fund.
Warren Buffet, Chairman and CEO of Berkshire Hathaway, once said, “Ninety-eight percent or more of people who invest should extensively diversify and not trade. Specifically, these investors should buy a very low-cost index fund.” By buying into an S&P 500 Mutual fund, you can own shares of all the stocks in the S&P 500 Index. You can also buy into diversified fund that owns a mix of 70% stocks and 30% bonds.
Before we discuss what mutual fund you should buy, let’s explore whether you should choose an actively managed fund or an index fund. John Bogle, the founder of Vanguard Mutual Funds, became convinced from his research that not a single actively managed mutual fund consistently beat the market. That is, none had a better return than the index that was used to benchmark them. Benchmarks are indices of various stock market and stock market sector prices that can be compared on a day to day or annual basis. Below are the most watched stock markets indices.
The Dow Jones Industrial Average (DJIA)
This is not actually an index but the daily sum of the 30 largest U.S. companies’ current stock prices of. Almost all of them are household names, like McDonald’s, Facebook, ExxonMobil, and Proctor and Gamble. The stocks are weighted in the sum according to their relative prices. For example, a $200 per share stock is weighted four times as much as a $50 per share stock.
The Standard and Poor 500 Index (S&P 500)
Standard and Poor is a credit rating company that created this stock index in 1957. It is composed of 500 of the largest U.S. publicly listed companies. It further disaggregates the U.S. economy into eleven sectors, and it then selectively chooses stocks from each of these sectors to match the total market capitalization of all the public stocks in those sectors. In the chart below, you see these eleven sectors and their weights.
- Information Technology: 24.4%
- Health Care: 14%
- Financials: 12.2%
- Communication Services: 10.7%
- Consumer Discretionary: 9.9%
- Industrials: 8.9%
- Consumer Staples: 7.2%
- Energy: 3.6%
- Utilities: 3.5%
- Real Estate: 3.1%
- Materials: 2.5%
The NASDAQ Composite (NASDAQ Index)
The National Association of Securities Dealers Automated Quotation Index has over 2,500 stocks in its index, all stocks, both domestic and international that are listed on the NASDAQ stock exchange. The NASDAQ stock exchange began operations on February 8, 1971 as the first electronic stock market. The NASDAQ Composite Index is made up of 40% tech stocks, so it is a heavy tech index compared to public stocks overall (which are only 20% tech stocks).
Let’s look at some examples of benchmarks. If the actively managed mutual fund had a broad range of hundreds of stocks in it, its annual returns would be measured against the S&P 500 Index, tracking the performance of the overall stock. If the actively managed mutual fund had a broad range of international stocks, its annual returns would be measured against a stock index of international stocks, such as the MSCIEurope, Australasia, Far East Index(EAFE), which is a broad index that represents the performance of foreign developed-market stocks. This Index was created by Morgan Stanley Capital International (MSCI) to track foreign developed markets. Many of the largest mutual fund companies, such as Fidelity Investments and Charles Schwab Company have created mutual funds that mimic this index.
Unfortunately, the number of actively managed funds that beat their benchmarks is well below 50%. In Barrons, Daren Fonda reported on this:
Fund managers gave investors yet another reason to avoid their products last year: Well below 50% of actively managed mutual funds beat their benchmark in 2019—and it would have taken a stroke of luck to pick a winner. Just 29% of active U.S. stock fund managers beat their benchmark after fees in 2019. That declined from 37% of funds beating their benchmarks in 2018, the average success rate over the past 15 years (2020).
In November 2019, Barrons gave a similar report card to actively managed funds:
Fund fows continue to favor index funds over actively managed funds…We found that 22% of active funds (182 out of 840 with 10-year records) beat the S&P 500 Index’s 13.35% annualized return for the last decade through Nov. 21. The vast majority of them were growth funds (Coumarianos).
Further, Wallick et al. summarize the research on whether investors can rely on past performance to predict future performance for a mutual fund:
It has long been stated that past performance is not indicative of future results, but many investors are still tempted to select mutual funds by recent performance. Philips (2012) confirms that past performance is no more reliable than a coin flip in identifying active managers who will outperform in the future. Not only is past performance an unreliable predictor, but according to significant research, most other quantitative measures of fund attributes or performance (such as fund size, star ratings, active share, etc.) are equally undependable when used to identify future outperformers (2013).
The other issue to note here is the cost of actively managed funds. Wallick et al. report that the average annual fees of actively managed funds are 0.87% while the average annual fees of index funds is 0.17% (2013). Nerdwallet reported almost the same fee structure averages for 2020. Vanguard states:
However, the traditional value proposition for many advisors has been primarily based on their investment acumen and their prospects for delivering better returns than those of the markets. No matter how skilled the advisor, the path to better investment results may not lie with the ability to pick investments or strategies. Historically, active management has failed to deliver on its promise of outperformance over longer investment horizons. (Bennihoff and Kinniry, 2018).
Can we as individual investors predict the funds that will best the indices each year? For the Wall Street Journal, Mark Halbert, a financial analyst who audits and reports on the advice of investment newsletters, says the answer is a resounding no; rather, it is more dependent on luck than skill (2020). Halbert reports that similar studies by a number of prominent researchers come to remarkably similar conclusions. Bradford Cornell, a retired finance professor at UCLA, measures the role of luck by comparing the greater dispersion of short-term versus long-term returns of mutual funds. Halbert applied Cornell’s algorithm to analyze several hundred investment newsletters, many of which are popular with day traders:
When applying Prof. Cornell’s formula to this data, 92% of the differences in newsletters’ annual returns is due to luck. When he [Cornell] applied the same formula to a sample of large-cap U.S. equity mutual funds, he reached the almost-identical conclusion (2020).
Further, according to Halbert, Michael Mauboussin, a managing director at Counterpoint Global, a division of Morgan Stanley Investment Management, analyzed how quickly a top-ranked manager falls back to the middle of the pack. Mauboussin’s rationale is that the faster this happens, the more luck is playing a role.
Halbert applied Mauboussin’s algorithm to forty years of investment returns from the advice given by investment newsletters (1980 to 2020). He tracked newsletters whose returns put them in the top 10% of all newsletter returns in a given year. Halbert states that if skill were involved, the newsletter’s return should be in the top 10% again in the following year. Unfortunately, on average, the top performing newsletters for one year ended up on average at the 51st percentile performance mark the next year. This is only slightly better than chance. Finally, the Dow Jones Indices (owned by the company that owns the Wall Street Journal) found that only 3.84% of U.S. equity funds that were in the top half of performers in 2015 (above 50% of all funds) were still in the top half of performers in 2019. (Halbert, 2020)
So, this is the bottom line: even the experts cannot beat the indices on a regular basis. It is impossible to guess who will be the lucky few who do beat them in any particular year. The best path to riches is to invest your money in a diversified index mutual fund with a non-profit mutual fund company like Vanguard or TIAA, reaping annual average returns of 9% to 10%.