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EverydayInvestor (< 20)

Only idiots invest in mutual funds in taxable accounts

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February 22, 2009 – Comments (18) | RELATED TICKERS: VTI , VEU , VTV

So says a smart guy at MIT who ran some simulations. A mutual fund manager would have to outperform the market by 4.3 percentage points per year before expenses to equal the performance of an index fund for a high-tax investor investing in a taxable account. Such performance is virtually impossible over the long run.

excerpt: 

"Mr. Kritzman calculates that just to break even with the index fund, net of all expenses, the actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis. For the hedge fund, that margin would have to be 10 points a year.

The chances of finding such funds are next to zero, said Russell Wermers, a finance professor at the University of Maryland. Consider the 452 domestic equity mutual funds in the Morningstar database that existed for the 20 years through January of this year. Morningstar reports that just 13 of those funds beat the Standard & Poor’s 500-stock index by at least four percentage points a year, on average, over that period. That’s less than 3 out of every 100 funds."

 

18 Comments – Post Your Own

#1) On February 22, 2009 at 11:10 PM, goldminingXpert (29.55) wrote:

I'm going to take this as a ringing endorsement for the new MF mutual fund, eh? ;)

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#2) On February 22, 2009 at 11:42 PM, PositiveAlstry (< 20) wrote:

Wow Everyday,

Being a little unpositive on the Gardner Brothers new business launch?

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#3) On February 23, 2009 at 1:23 AM, Tastylunch (29.33) wrote:

I agree with this smart guy at MIT 100%. Why pay extra for underperfromance?  the ETF and low cost brokers have rendered the mutual fund obsolete.

The odds are against you from the moment you start.

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#4) On February 23, 2009 at 1:36 AM, BigFatBEAR (29.16) wrote:

Just bought some VTI for my non-taxable Roth IRA on Friday, based partly on Vanguard's reputation and your endorsement of it.

Anyone know much about the tax implications of options trading in taxable and non-taxable accounts?

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#5) On February 23, 2009 at 9:39 AM, EverydayInvestor (< 20) wrote:

Bigfatbear - options for the most part are treated like stocks. If possible, try to get long term capital gains by holding LEAPs (assuming your strategy works, it is easy to lose money in options and I don't recommend trading them). Otherwise they are short term capital gains. If you do complex things you will run into straddle rules from the IRS which are incomprehensible to me.

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#6) On February 23, 2009 at 12:20 PM, anchak (99.86) wrote:

Well I guess I am 5% IDIOT  ..... I had each of the Index ETFs Michael put up in their Mutual counterparts in my Taxable account - VTI and VEU  were the only ones I did not liquidate last summer and held thru.

I also hold some regional funds from T Rowe Price - I think the indices are not that efficient ( I also own VWO - in its mutual form) beyond Developed markets and you need the ability to invest Directly in companies - folks you need to understand this - most regional INDEX ETFs are still ADR based - ie they dont really invest in stocks in the respective country bourses.

As always...Michael brings out a great point. Incidentally, Morningstar carries a TAX EFFICIENCY tab on all mutual funds - it shows the Post Tax returns and also a Tax Efficiency Ratio - I strongly encourage to consider those before deciding on your funds 

 

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#7) On February 23, 2009 at 12:55 PM, EverydayInvestor (< 20) wrote:

My wife holds Dodge & Cox International in her 401(k). Most mutual funds there is no tax efficiency whatsoever, 100%+ turnover, lots of short term gains.

anchak - could you give some examples of ADR-based ETFs? The broad Vanguard ones are not ADR-based. VWO & VEU, for example have only a few ADRs that I see. I would argue that anything more specific is just foolish. There is no need to own a Namibia ETF and a Turkey ETF and a Easter Island ETF (I exaggerate a little).

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#8) On February 23, 2009 at 1:22 PM, anchak (99.86) wrote:

Dodge & Cox is a VERY GOOD COUNTEREXAMPLE - that fund is fairly tax efficient - its essentially a VEU and VTRIX combo. But you are right - I am only talking about Asian countries which have ( or used to) a lot of restricitions on how you can invest ( or who can invest) etc....

FXI is a good example - it is a subset of Chinese stocks listed on Hong Kong ( a lot of them have ADR counterparts). Similarly most of the old India ETFs ( The new Wisdomtree is different and so also the old Morgan Stanley one I believe). And between these I like the TRP Asia fund - because that's pan Asia ( sans Japan) 

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#9) On February 23, 2009 at 3:15 PM, ahobbs (24.58) wrote:

I think an exception to your rule would be muni bond funds.  Beats having to pick individual bonds, and it doesn't make sense to hold them in a tax-defered account.

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#10) On February 23, 2009 at 3:45 PM, EverydayInvestor (< 20) wrote:

I should have said "actively managed mutual funds", although it is clear in the article I linked. Index funds or ETFs are better, mostly because they are more tax-efficient. That's my point.

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#11) On February 24, 2009 at 9:58 AM, Crimsonpm (51.71) wrote:

Thank you, this was very useful. I like the Easter Island ETF, how can I get a piece of that!

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#12) On February 24, 2009 at 2:55 PM, Gronkt (40.86) wrote:

From what I hear, the Easter Island ETF has very low turnover...

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#13) On February 24, 2009 at 8:19 PM, MarkPerkins1 (< 20) wrote:

good stuff. funny, I started working on a post on this a week or so ago similiar to this..great minds think alike. Mark Perkins

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#14) On February 25, 2009 at 10:14 AM, Glenn1985 (77.76) wrote:

These little studies mean nothing.  They simply take a lot of averages, and compare them to the S&P.  But you shouldnt do that because on average of course most "professional managers" are idiots.  It is easy to find the managers that are good.  Compare the S&P to Fairholme Fund, for example, and you will witness a mutual fund that has put the S&P to shame consistently.  Easy.  Most people have no clue how to evaluate a company, so investing over a long period of time really is for professionals, not the average Joe (obviously).

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#15) On February 25, 2009 at 11:24 AM, EverydayInvestor (< 20) wrote:

Glenn - actually, if you were to look at historical performance, almost no managers have beaten the market after taxes and fees for 10 years. And there is no way to predict which ones will. Every single study finds the same results. This also explains why TMF's Champion Funds newsletter is underperforming its benchmark (I wrote about that in the last month).

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#16) On February 25, 2009 at 1:44 PM, Glenn1985 (77.76) wrote:

You're partially right.  It is very hard to beat the market consistently without flaw, and 99% of the managers out there cant do it.  The 1% are hard to find, but not impossible.  It takes research to know in advance how they will generally do.  FAIRX has beaten the S&P every year since 1999 with the exception of 2003 when the market skyrocketed.  He invests / talks / behaves just like warren buffet did in the early years.  Take the analogy that if person A made straight A's all through high school and through three years of college, it is safe to say that this person will make an A in their senior year as well...  it is a very strong trend that you can bet on safely.

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#17) On February 25, 2009 at 2:12 PM, EverydayInvestor (< 20) wrote:

Glenn - your analogy does not work. Beating the market is not like getting straight As. It is like winning the world chess championships, because you have to beat other very smart people. Beating the market is a zero-sum game. Every bit of outperformance on the part of A means B, C, and D have underperformed by an equal dollar amount.

The problem with mutual funds is the same logic that led you to Fairholme could easily have led a similar investor to funds that have imploded (think Bill Miller here and LMVFX or Muhlenkamp MUHLX). Best case scenario, you get a fund that outperforms the market a little over the long run. Worst case, you underperform by a lot.

What is even worse, if you properly benchmark Fairholme, its outperformance decreases substantially. The fund has always held a lot of cash (15% now, according to Morningstar). In a down market, that means it will outperform. You should compare it to a benchmark of 15% cash and 85% VTI.

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#18) On February 27, 2009 at 7:23 PM, ahobbs (24.58) wrote:

What's lost in this discussion is the following simple rule:  A mutual fund is only as good as the individual securities that it invests in.  Too often people invest in a mutual fund based on past performance without regard to what the fund is currently holding.  Do so at your own peril.

I would suggest people always check out a fund's holdings before investing to see if they're comfortable with those holdings and investment style.  I would also recommend that people check-up on the holdings in the funds they own at least once a year and fire the manager (by selling) if you are no longer comfortable with their holdings or investment style.  This is only part of what a fund invester needs to do before investing, but I think it's an essential part that is often overlooked.

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