With the continuing surge in stock prices -- since the beginning of 1995, the Dow Jones Industrial Average has more than doubled -- and the consequent rush of small savers into mutual funds, the investment industry has lately taken to issuing public-spirited warnings of the "what goes up must come down" variety. "The rates of return we have seen are ... not the norm," noted the president of the Investment Funds Institute of Canada. "Fund investors should be advised of normal investing conditions, and the risks of an extended bull market." This is commendable enough. But if the people who sell mutual funds were really interested in warning of the risks of investing, they'd just say: don't buy our product.

One of the great mysteries of our age is the vast disproportion between the sales of mutual funds and their performance. Total assets under management, at $258-billion as of June 30, have never been higher; net fund sales in the first six months were up more than 50 per cent from the same period a year earlier; the number of unitholders has likewise increased 46 per cent. Industry profits have swelled accordingly.

Yet of the 15 largest Canadian equity funds, just three have succeeded in beating the TSE 300 index since the start of the year. While the index, a composite of the 300 largest shares listed on the Toronto Stock Exchange, posted a 16 per cent return through the end of July (assuming all dividends were reinvested), the average fund came in at just over 13 per cent.

Statistically speaking, the average return is what you would expect to earn if you picked among those 300 stocks at random: by heaving darts at the stock listings, say. You might do better than the index, you might do worse, but on average your returns would be about, well, average. So for all the sales charges and management fees that the mutual funds attach to their services, their clients were rewarded with substantially worse returns than they might have obtained by hiring a well-trained monkey.

This phenomenon isn't restricted to the big funds, nor is this a particularly unusual year in this respect. In any given year, it has been found that between two-thirds and three-quarters of all funds underperform the index.

Again, this is significantly worse than would be predicted by the laws of probability: if fund managers really were tossing darts, you'd expect roughly half of them to fall on either side of the index in a given year.

What explains this miserable record? It isn't that fund managers are stupid or lazy. Well, some of them are. But the truer statement is that none of them is so smart or diligent as to consistently outpace all of the other smart and diligent fund managers, each of whom is trying to outsmart and outwork the rest. The sum total of all of their best efforts is a standoff: nobody beats the market, and those that do are dumb lucky.

Which is to say that stock markets are efficient. Any information that might move stock prices probably already has; buyers and sellers quickly add it to their calculus of a stock's value, as reflected in market prices. No amount of past information -- for example, on the historical movements of stock prices -- is of any predictive value. But neither are future events, so far as they can be anticipated. The only information that moves prices is new information -- surprises, in a word -- which is inherently unknowable.

Hence the economists' dictum that stock prices are a "random walk." Not only is it impossible to tell which stocks will rise or fall, but neither are the movements of the market as a whole predictable. All of the advice from all of the experts, from brokerage analysts to market tipsheets to newspaper columnists, is so much wasted paper. As, for the most part, are the fees we pay to fund managers. You can't call the market, and neither can they.

Worse, even if there was one who could -- Warren Buffett springs to mind -- you have no way of knowing in advance who he is.

Fund managers protest that you can't "buy the average": even if you purchased those stocks yourself, you'd still have to pay a broker to put the order through for you. So even monkeys would tend to underperform the average. That's true: but most actively managed funds underperform the average, even before their fees are subtracted. Why is that? Because, being actively managed funds, they keep a part of their portfolios in cash. Over time, stock prices tend to rise more than they fall. Which means that any day you are out of the market -- that is, in cash -- is more likely than not to be a day the market rises.

What can you do about all this? You can't predict a fund's return. But you can predict one part of it: the fee it charges. As it happens, the funds with the lowest fees are also the most likely to stay fully invested: the so-called index funds that passively buy all 300 stocks in the index. Stick with these, and save your money. |