Why Do Mutual Funds Lag the Market?

One of the biggest misconceptions among investors is that actively managed funds usually outperform the market as a whole. It should make sense that a fund that is managed by an “expert” who is constantly looking out for the best stocks and monitoring earnings reports should be able to beat the average stock return. Shockingly though, a whopping 90% of mutual funds are losing to their respective indexes.

Mutual funds usually remunerate analyst and portfolio managers very well and are able to attract some of the top talents in the world. Furthermore, most of these analysts are paid based on performance and yearly bonuses are only released if the fund performs well. So how can some of the most educated, and brightest portfolio managers still continually fail to beat an index that mindlessly tracks an aggregate of stocks?

Higher Commission Fees

There are a few reasons why a mutual fund cannot outperform an aggregate of stocks (i.e. the index). Most significant of which is the fact that they charge a management fee. This can sometimes be up to 2% of the initial capital invested.

This means that the fund only has 98% of the initial capital to work with. Suppose that the index runs up 10% for the year. To match this return, a mutual fund instead needs to increase the initial capital by 12.24%.

This already puts the mutual fund on the back foot. To continuously outperform the market by that margin is not easy, even with the resources that a mutual fund has.

Actively Trading for the Sake of it

The other reason many mutual funds tend to underperform the market is that they move in and out of the market way too often. This happens because these funds are actively managed and investors expect a certain level of activity in their portfolio.

Imagine a billionaire who has put his trust in a fund to manage his wealth. On his quarterly meeting with the fund managers, he asks what changes have been made to the portfolio. The reply by the portfolio managers is that nothing has changed for three months. The investor who is paying a huge management fee will not be happy that the portfolio manager was inactive for the last three months and was getting paid to do so.

Therefore, despite the fact that doing nothing at all would be the best action to take, fund managers may sometimes be pressured to tweak the fund just to please their investors.

The Foolish Bottom Line

There are always going to be exceptions to the rule, and some of the star mutual funds can aggregate exceptional market beating returns. But most of the time, mutual funds, despite their legitimate motives and seemingly unlimited resources, still fail to beat their respective indexes.

It is not for the lack of trying, but the inbuilt disadvantages that they face because of how the industry works. Therefore, seasoned investors may, in fact, be better off putting money in an index fund or managing their portfolio themselves.

Meanwhile, for more (free!) investing insights, sign up here for your FREE subscription to The Motley Fool's investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.