Most Mutual Funds Don’t Beat the Market: A Closer Look at Market Performance
Investors often find themselves asking, “Did my mutual fund beat the market last year?” The answer isn’t as straightforward as it may seem; it largely depends on how one defines “the market.” This uncertainty can leave many investors perplexed, especially when considering the nearly 3,900 actively managed U.S. equity mutual funds and exchange-traded funds tracked by investment researcher Morningstar.
Understanding Market Performance
In the year 2024, only **13.2%** of these actively managed funds managed to outperform the S&P 500 (SPX), which yielded a **25%** return. These funds saw an average gain of just **13.5%**, barely half of the S&P 500’s performance. However, when evaluating performance against different benchmarks, some interesting trends emerge. For instance, **38%** of mutual funds outperformed the Dow Jones Industrial Average (DJIA), and **46%** surpassed the equal-weight version of the S&P 500 (XX:SP500EW), while **53%** exceeded the returns of the Russell 2000 (RUT).
Beware of Benchmark Shopping
Despite these figures, investors should remain skeptical of funds and advisors who engage in “benchmark shopping.” This practice can paint a misleading picture of fund performance. According to economist William Sharpe, a Nobel Prize laureate, an actively managed fund will invariably underperform an index comprised of the very stocks that the fund selects from. His insight can be traced back to his renowned article, “The Arithmetic of Active Management.”
Sharpe formulated a concept using two imagined portfolios: one consisting entirely of broad-market index funds and the other comprising portfolios of active managers attempting to beat the market. Together, these two portfolios represent “the market.” Since the index fund portfolio is, by definition, identical to the market, the active management portfolio must mirror it as well. However, trading costs will ultimately lead to an underperformance of the average actively managed portfolio compared to the market.
The Cost of Active Management
Sharpe noted, “the costs of actively managing a given number of dollars will exceed those of investing in an index fund.” This disparity arises because active managers incur additional expenses for research, trading, and compensating security analysts and brokers. As a result, the after-cost returns from active management fall short of those generated through index fund investments.
Implications for Sector-Focused Managers
It’s important to note that Sharpe’s argument also applies to active managers who concentrate on specific market sectors, including large or small cap, or growth versus value stocks. Provided that the benchmarks these managers compare their performance with include the same set of stocks they buy and sell, Sharpe’s overarching argument remains valid.
The Zero-Sum Game of Active Management
A key implication of Sharpe’s argument is that active management operates as a zero-sum game. In practical terms, if one active manager successfully beats the market, it implies that one or more other active managers would have to underperform. This notion of a zero-sum dynamic should engender considerable caution for investors in actively managed funds.
The Challenge of Competing with Technology
While individuals may harbor a belief that they possess superior trading acumen, it is essential to recognize that today’s competitors are often AI-driven supercomputers. The probability of a human successfully outmaneuvering sophisticated algorithms and high-frequency trading strategies is increasingly slim.
Conclusion: Investors Must Choose Wisely
In conclusion, the notion of “beating the market” is deeply interwoven with how investors define “the market.” With the vast majority of actively managed funds falling short of the S&P 500, sticking with indexed investments may prove to be the more prudent choice. Understanding the mechanics of fund management, costs associated with active trading, and the impact of competition from technology can empower investors to make informed decisions. Ultimately, the complexities inherent in fund performance should encourage a deep scrutiny of investment choices and strategies.