Why do mutual funds suck? And why are people still investing in them?
Mutual funds as an aggregate seem to have poor performance. Most can't beat the index in the long-run and lose to ETFs. And they still charge ridiculous fees. So what are they doing wrong? Why do hedge funds and other investment vehicles outperform mutual funds so greatly?
And if this is the case, why do retail investors continue to throw their money and savings into these funds year after year? How do they even know which one to pick? Demand has grown substantially but it seems like the mutual funds are enjoying a greater portion of the profit surplus.
Thanks in advance, just trying to make sense of this.
Hedge funds have more flexibility in terms of what they can invest in. Even so, there's still some mutual funds that do quite well, while there's some funds that are just eating away at your capital with fees. I'd almost say the same thing with HF's. There's always going to be under-performing funds eating away at your investment through fees and loss of capital.
People throw their money at mutual funds because its the easiest way to get your money into the markets. Whether through a 401(k) or some company sponsored plan, mutual funds are the preferred choice because of their safety and being well known.
I think 5 to 10 years down the line, ETF's will closely match mutual fund holdings as people become more proactive in their investments and the message about retarded fees gets really spread around.
A lot of mutual funds actually do beat the market before fees
Most mutual funds suck because most investors (professional or otherwise) are no better than dart throwers. Then, they throw fees on top driving most to underperform over long periods of time.
They actually don't. Check your sources.As a whole, index funds do fare better than many actively managed funds and ETFs can be cheaper than mutual funds. That doesn't mean there aren't very good mutual funds out there.
And ETFs aren't always cheaper. If you are paying a commission and dollar cost averaging with monthly investments then those commissions can end up costing more than the difference in expense ratios.
alpha is rare, expensive, and fleeting--even the mere hope of alpha has spawned a massive industry. "active" and "fundamental" investing has its place, but in the public securities markets we often mistake randomness for skill. hedge funds were a brilliant ploy in the sense that they charged 2/20 for what is basically just a bunch of more interesting beta (see aqr's delta fund)
spot on
Mutual funds charge a lot less than hedge funds, in general they outperform hedge funds, and they are accessible to retail investors. Where else (other than an etf) can you find an actively managed portfolio for an average minimum of $2k? Plus as previously mentioned most 401 plans rely solely on mutual funds for investments, and that gives you a captive audience adding money every couple of weeks.
I don't really understand the mutual fund business model.
Mutual fund PMs have a mandate to be invested in certain industries and/or growth/value type companies. Even when the markets are tanking and the macro view looks bleak they have a mandate to essentially be invested (its not the PM's fault as much as the investors' mandate). If PMs hold more than 10% in cash it looks like they aren't doing their jobs. As an investor you're still paying fees on a sizeable amount that is returning 25 basis points. And even if their sector is grossly overvalued they have to remain invested and buy at higher prices.
Inevitably over the long-term they will have market returns. "Alpha" will likely just be a function of the portfolio's beta. I feel like investors can get the some exposure just by buying ETFs. Obviously they'll have to monitor their accounts but even by using a simple P/E metric investors can gauge when their investments are theoretically under/over- valued. Ideally just place 50% of the $ in SPY and the rest in various sector ETFs. And now a days there are ETFs that cover so many random investment ideas. Credit Suisse just launched like a LGBT ETF lolz.
Their mandate is usually to outperform the market as measured by a benchmark...that's what investors pay for. Investors that don't want any beta probably won't be looking towards mutual funds, though there are some "hedged mutual funds" that toe the line.
I understand and was just being cynical.
I mean if the S&P is down 20% YTD and a fund is down 15% then its a "good" year right? The flexibility of HFs make them theoretically amazing but the problem is that 2/20 is insane and large HFs are ultimately correlated and track the equity indexes too.
Again, I think ETFs are the way to go. Sit on SPY and get in/out depending on the P/E. You'll miss some rallies but will be less likely a victim of a major pullback.
The mandate is more for the benefit of Wealth Advisors. If they are buying mutual funds for WRAP accounts, they want some guarantees that the mutual funds they are buying into wont suddenly invest in the same thing.
Aren't simple index funds much better for typical retirement minded investors?
They seem to outperform actively managed mutual funds, if just because of the lower fees.
The "money managers" I know seem to be nothing more than glorified casino gamblers with little to no real thesis behind their investments.
The fee structure of mutual funds seems to be the biggest problem. Charging a 2% MER if your fund loses money or doesn't beat the benchmark is really odd. A better solution is to charge performance-based fees. This also prevents funds from trying to gather as much AUM as possible simply to collect more fees. I recall reading that the greater the AUM, the worse the performance is because it's harder for any particular investment to make an impact and the portfolio managers start to closet index.
It is very difficult to generalize about mutual funds, as there are so many different styles and objectives within this broad category. Mutual funds are judged against their respective benchmarks, and too many people incorrectly assume that the benchmark for all mutual funds is the S&P500.
One common scenario is a mutual fund underperforming bull markets and outperforming bear markets, which actually may lead to better risk-adjusted returns than just holding an index ETF. Every investor has his or her own individual investing objectives and constraints, and there is definitely a place for mutual funds in the investing world.
It is another misconception that hedge funds outperform mutual funds. Again, it is difficult to generalize about hedge funds, considering there are so many different hedge fund investing styles, but in general, hedge funds mainly offer exotic beta exposures to investors. Many hedge fund returns are negatively skewed with a high kurtosis, and if you were to account for these additional risk exposures, you may find that mutual funds outperform hedge funds on a risk-adjusted basis.
Thanks for all the great responses, definitely learned a lot. My next question would be how do mutual funds differentiate themselves vs their competitors? There are so many different funds and they all employ the same marketing strategy of commissioning brokers or financial advisors to sell them. Seems to me like the industry shouldn't be terribly profitable but yet it is.
Track record, fee structure, personnel, etc.
Net of fees, theres pretty much no hedge fund thats going to beat the market (especially when properly benchmarked) over the course of several years. Also, when you look at the risk adjusted return, there are a decent portion of mutual funds that compare favorably. Plus its easy. Instant diversification, and shit that you don't have to worry about.
While this may or may not be true, HFs have a lot to offer in terms of broader diversification. It's not a one or the other thing (given enough capital obviously).
http://en.wikipedia.org/wiki/Alternative_beta
Who doesn't have time to invest in individual stocks? If I can do it working 120 hour weeks, I'm sure anybody else can.
Also, if you have a broker who puts your money into mutual funds, may God have mercy on your soul.
I think it's more about people not knowing how to invest. Investing takes very little time compared to trading, which is 24/7.
Exactly. It doesn't take a lot of time. There is some due diligence required, that most people on this website know how to do, but I still don't get how even senior level guys in high finance are that lazy. If Warren Buffet has the time and energy to do it, everyone does.
I've got a question for those of you who actively trade - how do you get around having all your gains eaten away by 15-40% every time you sell?
Eaten away by what?
trading what? equities?? you do know that places like options house have pricing for those who trade alot.
currency traders usually pay the spread and im sure bigger players in the futures markets have fixed rates as well.
the problem with hedge funds is that there are very few who produce super rock star returns and everyone thinks they're the cats meow. what you dont hear about is the funds who perform piss poor and dont produce shit
Once the top 5 managers started making 10 figs a year, everybody wanted to start, work at, or write about HFs.
After reading the thread, I feel like I should chime in.
1) Mutual Funds - They are great vehicles for instant diversification of your investment. As the name itself says, it's a fund of mutual investors. Not everyone has access to large amounts of capital to make the MPT model work in their own brokerage/WRAP accounts. So if you have X amount of savings to invest, I have Y amount, and everyone else in our office chips in Z amount, we now have substantial buying power compared to if we just each did our own thing. Based on this, we can also now effectively diversify our moneys. Beyond that, if we're all pooling our funds together, we can effectively create different fee structures that can accommodate our different preferences. I want to pay all my fees up front, I buy A shares. You feel that the gains from our fund are going to outstrip any fees, you buy C shares and pay an ongoing load. Or, we do a Vanguard style, and do true no-load funds. The caveat with mutual funds, depending on your investing/trading style, is that they're open ended and you can only enter/exit at the end of the trading day. The thing that begins to impact mutual fund performance is that as the size grows, and the prospectus mandates in place require them to continue to maintain a certain investment portfolio, you eventually become so large that the trades you have to make begin to work against you since you're soaking up everything available on the NBBO in a not as voluminous security for instance, and thus driving price against your fund. A great way around this is the advent of the all-asset fund, such as the golden boy (in my eyes) BlackRock Global Allocation, or Ivy All-Asset. For instance, in 2008, after SHTF, BlackRock Global's top holding was ES contracts, and lo it produced returns. Then, you have the "fund of funds" which is a mutual fund that only holds shares of...other mutual funds. That is something that definitely smacks of just gathering AUM to chase fees.
Fun fact: When you include all of the different share classes, there are now more mutual funds than listed equities.
2) ETFs - Built to hybridize the idea of the mutual fund along with the nimbleness of futures/equities. Take the idea of pooling money together in a mutual fund, but let's make it a closed end structure so we can actively trade in and out of our shares as the market is open. We can still add shares as needed, and we can use the funds to go out and purchase additional shares of equities as needed to compensate. Another thing here is that we don't want to worry about active management, we just want to track a certain index / future(s), so we can offer cheaper fees to boot. You also tend to see more exotic investment options such as MLP tracking funds, or the 3x levered QQQ short variant (almost all mutual funds won't use out and out leverage).
3) Hedge Funds - a somehow magical creature around these parts. As noted previously, most hedge funds are actually laggards in performance, comparatively. To answer the early question of why don't more people invest in hedge funds, they can't. In order to invest in a hedge fund you have to be an accredited investor which means (this is a fuzzy memory, so someone back me up here) over $1mm in assets and something like $250k liquid? Anyways, a vehicle for the top 5% basically. As noted, Hedge Funds have a lot more leeway in what they can invest in. Some funds diversify by purchasing commercial real estate, investing in PE firms, owning franchise chains, etc. Here you also get into the three different types of HF shops, the "commercial" shop, the philanthropy/endowment shop, and the family legacy shop.
So each investment vehicle has it's merits, and it's downsides.
I think a lot of people here are overlooking the fact that performance can work in both directions. We use the term upside and downside capture and there are many MFs out there that essentially give market performance net of fees while drastically reducing the downside when the markets turn ugly. For most retail clients this is far more important than getting a little alpha.
It's much easier to look at a MF expense ratio and its 1,3,5 and 10 year track record against lipper and S&P benches. I don't think it is an issue of time for most people, it's convenience and hassle to do individual stock picking, paired with an overall lack of confidence in the idea of "stocks." Most participants wouldn't be able to tell you what a capital appreciation fund is or what it consists of, but it sounds better than "the market," to them. Also it's not difficult to find no load funds, I dont think the 121b fee is an excuse to get out of MF's. I am a big proponant of ETFs and my firm is late to the party in that regard but MF's certainly can provide the hands off approach that most people prefer, especially the target date funds. A lot of plans limit what funds are in a plan so that is certainly a problem, and a lot of fund managers will close funds to new money if it performs too well, so that could explain some reasons why its difficult to find quality MFs.
It makes little sense to condemn all mutual funds based on average data. Hedge funds severely underperform on average as well. In both the hedge fund and mutual fund space there are phenomenal funds that have consistently delivered alpha, even after deduction of fees. A better question would be why people still invest in the specific funds that have consistently failed to generate alpha, rather than invest only in the winners. I would guess that asymmetric information and lack of access are the major reasons.
psychological comfort, most people (even very smart/educated) don't know much about finance
Ever wonder why fund managers can't beat the S&P 500? 'Cause they're sheep -- and the sheep get slaughtered. I been in the business since '69. Most of these high paid MBAs from Harvard never make it. You need a system, discipline, good people, no deal junkies, no toreadores, the deal flow burns most people out by 35. Give me PSHs -- poor, smart and hungry. And no feelings. You don't win 'em all, you don't love 'em all, you keep on fighting . . . and if you need a friend, get a dog . . . it's trench warfare out there sport and in here too.
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