Scott Burns: When it comes to one key mutual fund report, it’s not what they tell you, it’s what they don’t

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Imagine you’ve just stepped into a casino. It has only two games. Both have big stakes — your retirement.

One game offers a crowd of players who come, play and fold. It’s an exciting game. The odds are deeply stacked against winning, but winners make it big. There’s about a 5% chance that you’ll come out a big winner.

And there’s about a 15% chance you’ll do as well as playing the other game.

The other game is kind of boring. It’s never dramatic. But you know that if you stay, you’ll beat about 85% of all the other players.

Which do you choose? And remember, your retirement is at stake.

That’s a situation that Kiplinger’s, one of the big and often useful personal finance magazines, doesn’t tell you about in one of its regular features. It invites you to the mutual fund casino. It rings a bell and names the big winners. It shows you how high the winners’ returns were compared to the much lower figures for the average player.

Boy, those winning funds look good!

Wait a minute, you say.

Are you trying to tell me that Kiplinger’s is promoting casino gambling?

Not at all. It’s quietly promoting mutual fund gambling.

Allow me to explain.

Kiplinger’s has a regular feature on mutual fund performance. It seems to tell us a lot about the top funds in 11 mutual fund categories. Better still, it tells us the winners in those categories over time periods from one to 10 years.

The March issue deals with performance for periods ending last December. It tells us, for instance, that if we had wanted to invest in large company stocks and had chosen Morgan Stanley Insight A shares 10 years ago, we would have enjoyed a compound annual return of 23.1%.

That’s impressive.

Even if we looked at the bottom fund on its list of 10, Fidelity OTC fund, it would have provided a 19.5% annualized return.

Trust me, you should be impressed. The average fund in that category provided an annualized return of 12.5%. That’s a lot less. At the category average return, your money doubled about every six years. With the winners, it doubled about every three years.

Big difference.

The feature seems like a great public service. You see how the best funds in 11 categories performed. You get their names. And you see how they compare with the averages in their category.

So why do I find it profoundly annoying?

Here’s why: It’s a big display of misleadingly specific data. While it excites our hunger for big winnings, it has no redeeming investment value. The list of funds performs the same function as the bell that goes off in a casino when someone makes a lucky pull at the slot machines: It furthers hope in a game with poor odds.

Whether you are investing over one year or 10, having a list of top funds for that particular time is just a bell. It has no value for what we are interested in.

That’s future returns, not past returns.

Here are some of the facts that Kiplinger’s doesn’t tell you. Without them, you have no idea what the odds are in your personal fund picking game.

You had to pick from a lot of funds. Using the Morningstar database, Kiplinger’s provides performance figures on top 10 funds in each of 11 categories. It does this for four time periods: one, three, five and 10 years.

So lots of funds are listed.

The funds have typically been in the top 10%, or better, of their category for the time period. The problem is that those winners weren’t obvious when the investment was made. Basically, it was no better than a 1-in-10 shot.

Actually, the selection was far harder than that. Morningstar reports on, and ranks, funds that survive the given investment period. Mutual fund closings (and exchange-traded fund closings) are regular events. According to the most recent Standard & Poor’s Index Versus Active (SPIVA) report, the death rate for mutual funds remains high. It ranged from 5% to 10% across all categories in 2020.

But wait, it gets worse.

Some 96% of all large company funds that started 2020 survived the year. Only 87% of those started three years ago survived, only 77% of the five-year funds, only 63% of the 10-year funds and only 27% of the 20-year funds.

It turns out mutual funds are a bit like pets. Odds are, you will outlive them.

So while the lowest-performing fund in a Kiplinger’s list of 10 might be in the top 5% of surviving funds over the past 10 years, you are really choosing from a group that was much larger when you make your investment. That means the odds of picking a winner are worse.

The most certain way to beat the average performance for any category is to index. While Kiplinger’s provides the average performance in each time period for the chosen categories, the magazine neglects to mention the return of an index fund for the same category. Since most funds fail to beat their indexes, the odds are that an index fund will beat the category average by a healthy amount.

The longer the investment period, the smaller the portion of managed funds that beat the index they are measured against. While 60% of surviving large company domestic funds failed to beat their indexes over the past year, the fail rate reached 82% by 10 years.

It hit an amazing 94% by 20 years.

The SPIVA report shows similar failure rates for international stock funds, emerging markets stock funds and fixed-income funds. After 10 or 15 years, there’s about an 85% probability that a managed fund will fail to beat its index. That means that you, as an index investor, are likely to beat about 85% of all managed funds.

Investing, like life, is a game of bets and chance. We never know enough to be certain. We make the best decision we can, based on the facts we know.

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