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This chapter is from the book

Bad Performance: The Final Straw

Although some of these funds have made amends and worked hard to restore their relationships with investors, trust is proving difficult to get back. Financial reporters who had been strong supporters of mutual fund investing changed their tone and started to increase their criticism of mutual funds. John was one of them.

It wasn’t long before shareholders, too, began to demonstrate their displeasure with certain funds. At the time of the downturn and the scandals, there was an increase in the amount of performance analysis of mutual funds: Were they really as good as people thought? It turns out that the answer was a resounding no.

Studies revealed fewer than 10 percent of active funds outperformed their benchmarks over time. If nine out of ten mutual funds trailed the S&P 500 index over time, you might rightly ask, “Why own a mutual fund?”

Then investor advocates started measuring returns through asset weighting. This method looks at performance based on when you actually purchased shares. Most investors bought into funds at the height of their run-ups, then rode them on the way down. They weren’t getting the returns the fund companies were advertising.

In the wake of the market decline, the scandals, and the realization that few funds outperformed their benchmarks, the number of mutual funds began to consolidate. Today there are a little more than 8,000 mutual funds, down from a high of 11,000 at the market top in 2000. Each year, 300 to 500 mutual funds are lost because poor-performing funds are being killed off or merged with other funds that have better track records.

You would have thought that the scandals chastened the industry to offer full disclosure on all their portfolios, but that didn’t happen. In many cases, the directors of the funds—the stewards representing outside investors—are often the very people running the management company. That has been changing with the addition of independent directors, but plenty of conflicts are still built into the system.

To this day, you still don’t know how much managers are costing investors in terms of bad trades or total transaction expenses. These are hidden from view because if they revealed the total impact of these costs, returns would diminish even more.

Once again, Bogle was right. Costs matter big-time because performance suffers. The firms that paid attention to this message have benefited the most. Ninety cents of every new dollar invested in mutual funds today is sent to one of five fund companies: Fidelity, American Funds, Vanguard, Barclays, and Dodge and Cox. None of these five companies was implicated in the mutual fund scandal. Don’t get us wrong: There are many great mutual funds out there, although very few of them are actively managed. Index funds, which can be most efficiently packaged in ETFs, make the most sense for the majority of investors.

That begs the question: If actively managed mutual funds aren’t meeting their benchmarks and the lack of transparency has been an increasing problem for investors, why not go straight to the source? Why not just buy the index?

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