If You Own Stock Mutual Funds Read This

November 14, 1997

I just checked the returns for October on ten Fidelity mutual funds. Only one fund (10%) did better than their corresponding index. For example: Fidelity Contrafund lost 5.95% in October when its corresponding index (The S&P 500) only lost 3.34%. Fidelity Latin America Fund lost 22.36% in October when its corresponding index (Latin American Index) only lost 19.0%. Fidelity Worldwide Fund lost 7.6% in October when its corresponding index (World Index) only lost 5.28%. Virtually every fund I checked lost more than 2% more than its corresponding index. That's 2% more loss in just one month.

As a customer of Fidelity I clearly would have been better off buying the corresponding index vice buying one of Fidelity's so called professionally managed stock mutual funds. If I had bought index funds my losses would not have been as great in October, my overall returns for 1997 would be higher, and I would have saved money on expenses because index funds are cheaper to maintain.

Mutual fund companies (not just Fidelity) seem to be telling investors to hang in there for the long-term which investors are doing, but in return for their commitment to the long-term, mutual fund companies, for the past 3 years, are consistently showing their customers that they can no longer compete with the indexes. Their so called professional management of America's retirement money just isn't working anymore.

(Beware of 5 and 10 year return performance numbers. Prior to 1995 individual stock selection was more important and it was not unusual for a stock mutual fund to beat an index. As the mutual fund companies tell you, past performance in no guarantee of future performance. That is, don't let good returns of earlier years, 5-10 years ago, hide the poor performances of stock mutual funds for the past 3 years. Note: I'm talking about performances when compared to the S&P 500 index, performances may seem good now because the market has been on a roll. It is not unusual for a mutual fund to brag about how it has returned 20% for the past year, what they don't tell you is the S&P 500 index is up over 30% in the last year. You are paying that mutual fund company money for professional management which means getting a return equal to the S&P 500 is average, getting a return less than the S&P 500 is below average even if it is still a double digit number.)

I highly suggest that you look at your returns for October and year to date and see how your funds performed when compared to their corresponding indexes. It is very easy to do. For Fidelity fund holders there is a link right from this web page to check your performances.

After checking your returns for October and year to date you may find yourself asking yourself the same question that I am asking myself. As stock mutual fund holders, should we continue to pay mutual fund companies money in the form of "fund expenses" for professional management when we are clearly not getting even average returns when compared to a corresponding index?

One final thought. Remember that the financial news media will be the last people to tell you that the stock mutual fund industry may not be performing up to average standards. They know that part of those expenses that the mutual fund companies receive from their investors are distributed back to them in the form of advertising dollars. They are not about to cut off they main artery of revenue.

ADDENDUM (January 14, 1998)

In the Winter 1998 issue of Stages, a Fidelity investments magazine of personal finance, the cover story is about how to judge the performance of your stock mutual funds. The article states, "Investors often sell their shares in mutual funds that have failed to keep pace with the DOW, the S&P 500, or some other index. But a fund's returns might lag behind index gains simply because the fund invests in small-company or overseas shares the benchmark doesn't include." (All investors need to do is to make sure they pick a corresponding index when they compare.) Fidelity goes on to give the reader plenty of other "sound" reasons not to compare your fund's performance to a corresponding index. When you look at it from Fidelity's point of view you can see why they don't want you to compare your fund's performance to an index. For the past three years most of Fidelity's stock mutual funds have performed significantly below the averages.

If investors did compare, they may find out that they would be much better off just buying an index fund. If more investors started buying index funds that would hurt the bottom line of Fidelity because index funds are the least expensive to maintain and the least profitable for the mutual fund companies.

When deciding on rather to transfer to index funds or not you must first answer a very important question: Index funds have beaten most stock mutual funds for the past three years, will this continue in the future? I believe it will. I'm not saying that index funds will continue to beat as many stocks funds and beat them as badly as they have in the past three years, but I do think that index funds are a stock mutual fund investor's best bet.

The mutual funds industry itself controls over a third of all assets listed on U.S. exchanges. Even though it's in the best interest of mutual fund companies to invest this money they control in many different stocks and sectors, they themselves, are the biggest buyers of the large cap stocks. What I'm saying is that the mutual fund companies are telling you not to buy index funds when they themselves are the biggest buyers of the large cap stocks which make up the indexes. This heavy buying in large cap stocks by the mutual fund companies and institutions in general is what drives up the performance of the index and inturn the mutual funds that invest in those indexes (index funds). Bottom line, the mutual fund companies don't want you buying index funds because their profits are not as good in those funds, but as long as the mutual fund companies and institutions in general continue to put the vast majority of investment money in large cap stock, index funds will continue to beat most stock mutual funds.

I believe that mutual funds and the institutions in general will continue to invest mainly in large caps. The managers of mutual funds and many pension funds are inexperienced and sheep. They will continue to invest in what they perceive is the safest investment: large cap stocks.

Note: To see for yourself how most mutual funds own mostly large cap stocks look at your fund's annual report next time you get one. You will see that most funds have 30, 40, 50% of their assets in just ten stocks (20-30 stocks for larger mutual funds). Even specialty stock mutual funds do the same thing. Take for example a sector fund that invests in computers, most of the fund's assets will most likely be in Microsoft, Intel, Compac, and Dell (The article in Stages stressed diversity, but most mutual funds don't diverse that much, just look at Microsoft and Intel, these two stocks by themselves make up almost 20% of the total capitalization on NASDAQ, who says these stocks are worth that much, the mutual fund companies and institutions that are the biggest buyers of the stocks, that's who.)

ADDENDUM (June 6, 1998)

Just a reminder in this week's issue of Business Week (June 15, 1998) they have a article, "Speaking Past the Index Funds." "Most portfolio managers didn't come close, of course. But a few have found a way." With the "of course" it looks like Business Week didn't expect the portfolio managers to be able to beat the index funds either. The BW article goes on, "In each of the past four years, the highly trained and richly compensated folks who manage U.S. mutual funds have been humbled, if not humiliated, by the funds that blindly buy the stocks in the standard & Poor's 500-stock index. And this year is no exception. In the first five months of 1998, the average U.S. diversified equity fund earned a shade under 9%, vs. a little more than 13% for the S&P 500, according to Morningstar Inc." If you are still paying higher expenses and getting poorer porformance from your mutual funds, you may want to seriously consider changing to index mutual funds.

If you still are not convinced about how much better index funds are, here's another issue to consider. Index mutual funds have a lower turnover so capital gain distributions are less, on average, then with regular mutual funds. If your regular mutual funds are not tax sheltered (401k, IRA), you are probably paying more taxes on top of paying more for expenses and getting less performance to boot.

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