Stock Mutual Fund Efficiency

Posted on: May 2, 2013 by Martin Curiel, CFA in The Efficiency Philosophy

The idea for launching MYeCFO was conceived from our years of witnessing individuals paying high fees for financial products and services where cheaper – and often more effective – alternatives existed. Although one can apply the concept of efficiency to all financial issues – insurance, real estate, cash flow management, charitable contributions, etc. – we will begin this series of ePerspectives by discussing stock mutual funds. These instruments are one of the most commonly used products to build investment portfolios; they are also one of the most susceptible to rampant inefficiencies.

What does it mean to be an “efficient investor”? And how does one know if one has reached the enlightened state of efficiency? Although this concept can seem a bit esoteric, there are a few practical ways to measure it.

Most mutual funds in the marketplace are “actively managed”; in short, investors give money to a team of skilled and experienced investment professionals (the “manager”) to pick the best stocks out of a given universe. For example, the mutual fund strategy might call for selecting from a universe of large U.S. stocks. An investor might purchase a mutual fund – let’s call it Big Boy Mutual – that has a mandate to select the best 50 large U.S. stocks in existence. We can assume that the universe of large U.S. stocks – the complete set from which Big Boy Mutual can choose – is the S&P 500 Index. The fact that the manager selects only a subset of the S&P 500 Index – as opposed to simply buying all 500 large U.S. stocks that make up the index – is what defines the concept of “active management.”

Performance Efficiency
So if we give our hard-earned money to Big Boy Mutual, how do we know if Big Boy’s fund is “efficient”? One way to think about this question is to compare Big Boy’s returns to what we could earn using the cheapest available alternative. In the example above, if Big Boy Mutual returned 15% over a given year, then one could compare that return to the return of the Vanguard’s S&P 500 Index Mutual Fund (Symbol: VFINX), which buys all 500 of the largest U.S. stocks. A 15% return over a 12-month period would truly excite the average investor. “I made more money than the cash I have in the bank,” some would say, full of positive energy.

However, if during this same period of time, VFINX returned 16%, then we could conclude that we were inefficient in making the investment with Big Boy Mutual. In essence, by choosing an active manager, we destroyed 1% of value from our portfolio; assuming a $1 million portfolio, that translates to $10,000 in a given year. This destruction of wealth could persist for many years to come.

Now, it is very possible that VFINX could have underperformed Big Boy Mutual, which could have a very skilled team that can consistently identify the best 50 stocks out of the S&P 500 Index universe. It is important to note, however, that most actively managed mutual funds have historically failed to beat their passive counterparts over the long term. We will cover this phenomenon in later articles, but the bottom line is that the odds are stacked against most active managers. In short, performance efficiency can be examined by simply comparing one’s actively managed funds (or entire portfolio of funds) to their respective alternatives available in the marketplace.

Management Fee Efficiency
A major reason for the performance inefficiency of actively managed funds stems from the issue of manager fees. In order to cover the salaries, travel, and other costs of the “skilled investment professionals” that are spending their time and energy looking for the best stocks, investors must pay a fee. Generally, this is expressed in mutual funds as an “expense ratio.” According to Yahoo Finance at the time of this writing, actively managed mutual funds charge an average annual expense ratio of 1.1%. As a quick comparison, according to www.vanguard.com, VFINX charges 0.17% annually, which is more than 85% lower than the average expense ratio of actively managed funds. Yes, the extra expense charged by Big Boy Mutual and others could certainly be worth every penny if their performance ends up exceeding the cheaper index fund. In this example, one can see that a six-fold difference in fees is a significant hurdle for active managers to overcome.

Transaction Cost Efficiency
It is likely that Big Boy Mutual will turn over the portfolio more in a given year than a comparable index mutual fund such as VFINX. This extra buying and selling of securities creates transaction costs such as trading fees and market impact that ultimately erode the returns to the end investor. VFINX has a turnover ratio of 4%, much lower than the average of 52% for funds in the same category. Again, this is worth the extra cost if the active manager outperforms VFINX, but most do not.
To summarize our observations:

Disclosures: Non-deposit investment products are not FDIC insured, are not deposits or other obligations of MYeCFO, are not guaranteed by MYeCFO, and involve investment risks, including possible loss of principal. The information contained in this article is for informational purposes only and contains confidential and proprietary information that is subject to change without notice. Any opinions expressed are current only as of the time made and are subject to change without notice. This article may include estimates, projections, and other forward-looking statements; however, due to numerous factors, actual events may differ substantially from those presented. Any graphs and tables that make up this article have been based on unaudited, third party data and performance information provided to us by one or more commercial databases or publicly available websites and reports. While we believe this information to be reliable, MYeCFO bears no responsibility whatsoever for any errors or omissions. Additionally, please be aware that past performance is no guide to the future performance of any manager or strategy, and that the performance results displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future. Therefore, caution must be used inferring that these results are indicative of the future performance of any strategy. Index results assume re-investment of all dividends and interest. Moreover, the information provided is not intended to be, and should not be construed as, investment, legal, or tax advice. Nothing contained herein should be construed as a recommendation or advice to purchase or sell any security, investment, or portfolio allocation. Any investment advice provided by MYeCFO is client-specific based on each client’s risk tolerance and investment objectives. Please consult your MYeCFO Advisor directly for investment advice related to your specific investment portfolio.