Read This Before You Buy a Mutual Fund

The next time your broker recommends a mutual fund that is likely to "beat the markets," ask this question: Do you have more sophisticated information than the mutual fund managers themselves?
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According to the 2014 Investment Company Fact Book, the mutual fund industry in the United States manages an astounding $15 trillion in assets. That represents a whole lot of investors who must be disappointed with the performance of their actively managed mutual funds.

Approximately 85 percent of active large-cap stock funds underperformed their benchmark indexes through Nov. 25, 2014, according to an analysis by Lipper, a division of Thomson Reuters.

The rationale behind purchasing actively managed funds is their purported ability to "beat the markets." Financial pundits, brokers, insurance companies and many advisors claim they have the ability to identify and select outperforming mutual funds. Making the case for this "expertise" essential, otherwise everyone would simply buy index funds, where you earn the returns of the index, less low fees and assuming no tracking error.

Anyone can tell you how a particular mutual fund performed in the past, but basing investing decisions on past performance is akin to driving while looking only in the rearview mirror.

But what if your broker told you he consulted with mutual fund managers and asked them to select which of their peers was likely to outperform the market in the future? Wouldn't you be impressed?

Unfortunately, according to a recent study, you would be disappointed in the results.

The authors of the study reviewed actively managed U.S. mutual funds between 1991 and 2013. They identified "copycat" funds, defined as funds where the changes in portfolio weights matched by 75 percent to 90 percent of a target fund's trades in two or more consecutive periods. The premise of the study was that fund managers would only attempt to replicate the holdings of another fund if they had determined that the fund being copied was likely to have superior performance in the future.

The study found that "even the most sophisticated investors (other mutual fund managers) appear unable to identify superior mutual funds..." Fund managers who engaged in copycat practices used the same methodology employed by many brokers. Specifically, they selected funds with strong past performance and high investor inflows. The study found the performance of the funds being copied took a dive shortly after the copycat strategy was initiated. And during the four-year period after the copycat behavior began, the performance of the copycat funds declined by an average of 3.2 percent.

The authors of the study reached this sobering conclusion: "Overall, we find little evidence that fund managers are capable of detecting other superior fund managers ex ante."

The next time your broker recommends a mutual fund that is likely to "beat the markets," ask this question: Do you have more sophisticated information than the mutual fund managers themselves?

After all, even they were unsuccessful in identifying outperforming mutual funds prospectively.

2014-04-01-Hiresfrontbookcover.jpgDan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth adviser with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is The Smartest Sales Book You'll Ever Read.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisery services.

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