4. The Report Mutual Funds Don't Want You to Read

What's the report mutual funds don't want you to read? That's what I'm talking about on this episode of The Atomic Retirement Podcast.  

Resources Mentioned

• S&P Dow Jones Indices End of Year 2021 SPIVA U.S. Scorecard 
• Average Cost of Active & Passive Funds from Investopedia
• How Mutual Funds Mislead Investors 

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Transcript

Ryan Kilkenny  0:00  
Hi everyone, and welcome to The Atomic Retirement. I'm your host, Ryan Kilkenny, the founder of Atomic Planning, an independent, veteran-owned, fee-only financial planning firm bringing tax and retirement planning to families over age 50. Atomic Planning is a virtual financial planning practice in Kansas City, serving families from coast to coast from California to North Carolina. Thanks for joining me this week and welcome to episode four of The Atomic Retirement. 

Ryan Kilkenny  0:28  
What's the report most mutual funds don't want you to read? It's a 39 page U.S. SPIVA scorecard from the S&P Dow Jones indices. I said SPIVA and it stands for the S&P index versus active. I'll say that again. S&P index versus active, SPIVA. 

Ryan Kilkenny  0:59  
Twice a year, the S&P Dow Jones indices publishes a new SPIVA scorecard that measures mutual fund performance relative to their benchmark. They publish a mid-year scorecard running through the end of June, and an end of your scorecard with data through December 31. And guess what? They just released their end of year 2021 scorecard. But before we jump into it, let's make sure that we understand a few of the basics. Stocks and bonds, maybe you've heard of them. 

Ryan Kilkenny  0:59  
What is a stock? A stock, also known as equity, represents partial ownership of a business. That's right. When you own a share of a company stock, you own part of that business. The more shares you own, the more of the business you own. And by that what I really mean is that you have a claim on the company's assets and earnings. You don't technically own the business; you own shares issued by the business. So please don't go walking into the store and just carrying stuff out because you own shares. You don't own the merchandise, the business does. That said, when I say stock, I want you to think business. 

Ryan Kilkenny  2:07  
What is a bond? Well, we're not going to talk much about them today, but we still need to know what they are. And so a bond is debt issued by a business or government. When you buy a bond, you expect to be paid back your principal plus a little interest. In effect, it's like loaning money to a business or government. You can own individual stocks or bonds, or you can pull your money together with other investors and purchase a mutual fund. 

Ryan Kilkenny  2:35  
So what's a mutual fund? I'm paraphrasing Investopedia here, but a mutual fund is a type of financial vehicle made up of a pool of money collected from many investors so that they can invest in stocks, bonds or other assets. Mutual funds are operated by professional money managers who allocate the funds assets and attempt to produce capital gains or income for the funds investors. Mutual funds give small or individual investors access to professionally managed portfolios of stocks and bonds. Each shareholder therefore participates proportionally in the gains or losses of the fund. Mutual funds tend to be actively managed, which means professional money managers are actively buying and selling stocks and bonds on a daily basis. There's another type of pooled investment vehicle that operates a lot like a mutual fund. It's called an exchange traded fund, also known as an ETF. 

Ryan Kilkenny  3:27  
ETFs can be bought or sold on a stock exchange the same way that you buy a regular stock. Another benefit of ETFs is that you can see their current price as they trade throughout the day. Mutual funds are less transparent, and you can't see their price throughout the day. So if you buy or sell a mutual fund, you won't know what price you're actually paying or selling at until market close. Back to ETFs. Most ETFs track a particular index. And the s&p 500 is an example of an index, and that brings us to index funds. 

Ryan Kilkenny  3:59  
An index fund is a collection of stocks or bonds designed to mirror the performance of an index. Index funds are passive, meaning you don't have a professional manager actively buying and selling stocks and bonds. The index fund just adjust to what collection of stocks or bonds inside the index are doing on a daily basis. Warren Buffett recommends index funds for most investors, and remember, most ETFs track an index, so a lot of people using the term index fund and ETF are using them interchangeably. Okay, that pretty much covers the basics. 

Ryan Kilkenny  4:35  
So now let's get to SPIVA, which again stands for index versus active. All mutual funds have a benchmark index against which they measure their performance. It's their opponent and they want to beat it. Did you know that mutual funds get to select their own benchmark index? That's right. Mutual funds get to select their own competition, and they've been known to cherry pick an index that they think they can beat. They can even switch their benchmark index when they start to underperform it. These are a couple of their dirty secrets, and I don't know if you've seen the movie The Dictator, staring comedian, Sacha Baron Cohen, the same guy that played Borat, but in that he plays an admiral that is the dictator of the fictional Republic of Wadiya. In the movie, there's 100 yard dash where he's a competitor. He starts in lane six, and the sprinters take their marks. An announcer says, "get set." Well, he starts sprinting early, you know, to get a head start on his competition. And guess what? He also has the starter's gun in his hand. A few steps into his sprint, he fires the gun into the air and the rest of the competitors start to sprint. Well, he's not that fast, and so obviously, his competition starts to close the distance on him. And when they do, he begins to shoot them so he stays ahead in the lead. Yeah, the starter's gun he was carrying had live ammunition. And so then it ends, the race ends with two of his minions also running the finish line to him, so that he crosses it first. And you know what? Mutual Funds Act just like the admiral in the dictator. When the competition they thought they could be it starts to close in, they shoot it and change their benchmark index. I'll put a link to an article in the show notes. It's called, "How mutual funds mislead investors", and it digs into this topic. 

Ryan Kilkenny  6:28  
Do you know what mutual funds aren't allowed to do with SPIVA? You guessed it, they can't cherry pick an index. The S&P Dow Jones indices picks the most appropriate index for them. And it turns out most of them are underperforming their competition. The chart I'm going to talk about is on page 10. It's called the percentage of US equity funds. Remember, equities mean stocks. So the percentage of US equity funds underperforming their benchmarks. The chart data is in absolute returns, which means with dividends. Most people just call that total return. And so there are 18 different active fund categories in the chart. And each of the 18 has a comparison index. That's the active funds competition, the index they are measured against. And so the chart shows past performance going back one year, three years, five years, 10 years, and 20 years. Okay, I'm going to cherry pick a few of the data points here that I think are worth mentioning. Remember how I said there were 18 different active fund categories? Well, over a one year period, so basically all of 2021, active funds underperformed passive funds in 16 of the 18 categories. So all but two. The only two categories where active managers shined were large cap value and mid cap core. But, that performance seems to be a fluke, because if you go out to 10 years active funds underperformed passive funds in all 18 categories. And it was the same at the 20 year mark. Active funds underperformed passive funds and it's not even close. Active funds fared best in large cap value, but 83% of them still underperformed the S&P 500 value index, and 95% of all large cap core funds underperformed the S&P 500 index. That's pretty crazy. Right?

Ryan Kilkenny  8:28  
Wait, what's that? I think I can hear the moans and groans from professional money managers. Yep. Okay. All right. They're saying they beat the index on a risk adjusted basis. Folks, page 11 of this SPIVA report shows they did worse on a risk adjusted basis. For example, 97.99% of large cap core funds, underperform the index on a risk adjusted basis. So to recap, they got walloped on absolute return, and again, on risk adjusted returns. 

Ryan Kilkenny  9:02  
But we can see the past winners Ryan. Shouldn't we just select them and call it good? Well, I probably wouldn't and here's why. Will the winners continue to outperform? Nobody knows. And we won't actually know the answer to that question for another 20 years. What we can safely say, though, is that the odds are definitely not in their favor. Sure, there's a chance they could continue to outperform, but there's a much greater chance that they won't. 

Ryan Kilkenny  9:28  
What makes you feel more comfortable? Keeping your costs low and letting more money stay in your account to compound and grow, and getting market returns the beat the vast majority of active managers over the past 10 and 20 years? Or, would you rather pay a little more for your investments for a small chance the winners continue to outperform, getting whatever return they managed to drum up and knowing you are much more likely to underperform the market? 

Ryan Kilkenny  9:56  
Isn't that the ultimate irony underperforming because we try to outperform? I don't know, but perhaps that question is a good starting place to point you in the right direction for yourself. 

Ryan Kilkenny  10:07  
So why are mutual funds so problematic or bad at beating their index? There are three key reasons. 

Ryan Kilkenny  10:15  
Number one. They charge too much. According to Investopedia, the average cost for an active managed fund was 0.66%. But the average cost for a passive fund was only 0.13%. That's a savings of 0.53% a year, a little over a half a percent per year, or if you want to think of it this way, the average active fund costs five times as much as a passive fun. As we can see, the additional cost is a drag on performance. And the vast majority of active managers aren't returning performance greater than the fees that they're actually charging. 

Ryan Kilkenny  10:56  
Number two. As it turns out, professional investors have something in common with new investors. They're both human. People like to overestimate their abilities. Nobody wants to believe that they're average, or even worse, below average. But if somebody is average, it means they fall smack dab in the middle, which means there are a lot of people that are below average, technically 49.9% repeating have to be below average. But you know what? I bet if I polled a list of people on their driving ability, and I asked, how good are you behind the wheel? I would venture to say that a lot more than 50% of them would say that they are above average drivers. Or is that just me being overconfident? 

Ryan Kilkenny  11:42  
Number three. Market timing is impossible to get right consistently. What's the market going to do tomorrow this week, month or year? I have no idea. And neither does anyone else for that matter. Equities tend to move around a bit. Sometimes they move around a lot, especially if we're talking about individual stocks. Think about it though. In order to successfully time the market, lightning must strike twice. That's right. You have to be right twice, when you buy and sell or vice versa, otherwise it won't work. 

Ryan Kilkenny  12:16  
Okay, I've given active funds a pretty bad rap today, but I will say this. I very much believe that personal finance is personal. And people tend to stay invested when they are comfortable with their investments. If being in a mutual fund makes you feel comfortable, and it helps you stay invested. I call that a win. 

Ryan Kilkenny  12:36  
As a reminder, links to all the resources I shared will be in the show notes. 

Ryan Kilkenny  12:40  
That's it for this week. If you have any questions want to learn more, or see if we'd make a good team, you can find me at atomicplanning.com. There's a "Contact Us" button in the upper right hand corner of the website that makes it easy to schedule a Zoom meeting with me. 

Ryan Kilkenny  12:54  
Do you love the podcast and find it helpful? If so, I'd really appreciate it if you hit the subscribe button, leave a five star review and a short comment. It really helps people find me. And spread the word. Please share it with someone you think may enjoy it too.

Ryan Kilkenny  13:10  
This podcast is for informational and educational purposes only, and should not be relied upon for any investment, tax, or legal decisions. Clients of Atomic Planning may maintain positions in the securities discussed in this communication. I try my very best to bring you valuable information, but I may not know anything about you or your personal situation. So please talk with your fee-only financial planner, tax, and or legal professionals before taking any action or making any decisions about your own financial plan. Atomic Planning is a veteran-owned Kansas state registered investment advisor providing independent tax and retirement planning.