Are Mutual Funds Underperforming?

Mutual FundsMagnifying glass

A recent study conducted in the United States, tracking the largest cap stocks in the U.S. market, found that 78 per cent of actively managed mutual funds under-perform the general stock market index.

The reasons being, some investment experts say, are two key structural issues:

  1. Too many people are managing the bigger mutual funds, making safe decisions in group consensus. If a mutual fund had only one, or two managers, perhaps they would be willing to take on riskier, more aggressive entities. But then it’s the safety in number theory that compels so many investors buy into large group-managed mutual funds. The result is that these safe-handled mutual funds ends up mirroring an index fund, only an index fund doesn’t charge the management fees mutual fund managers do.
  2. A large mutual fund is structured to buy too much at once. For example, if a mutual fund holding $1-billion in assets (which is still relatively small in the U.S. mutual fund market) allocated 2 per cent of its holdings into one entity, they are assigning $2-million to that stock or holding, thereby raising the price of that stock against its own purchasing objectives. If it tries to sell this stock later, it will have the reverse negative effect. The stock will decrease in value, even if the mutual fund tries to spread out the selling. It will infiltrate too much of the stock back into the market, lessening its selling price.

Is the same thing occurring in Canada?

According to Dan Hallett, writing for the, though the route to the answer differs slightly, the answer is still yes. He blames the under-performance of mutual funds in Canada on portfolio dilution, the result of holding two or more managed funds composed of the same type of stocks, and offers for example, holding more than one large cap Canadian involved mutual fund.

“[Dilution] is where the portfolio risks becoming more index like but with active management fees,” he says in an article entitled Causes of under-performance not what they appear. “ That will doom any portfolio to long-term under-performance.”

Hallett contests that there is an overabundance of similar mutual funds, all investing in Canadian stocks, available in Canada, and that of these mutual funds, 90 per cent are not worth investing in. He stresses diversification and portfolio balance to guard against a portfolio looking like an index fund.

What is the best route to take if mutual funds are drastically under-performing?

If your mutual funds have lost money and selling would result in you paying deferred sales charges or other fees, there are two remaining courses of action you can take.

  1. Wait it out. Most Canadians hold mutual funds for the long-term, meaning terms over seven years. Generally, what comes up must go down and vice versa.
  2. See if you can switch. Investigate if there is another mutual fund you can switch your funds to without having to pay fees. Do your research. Selecting the right mutual fund could mean recovering all of your losses in due time.
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