The Truth about Mutual Funds: Fees Vs. Returns

There's a lot frustration and disappointment with mutual funds. For many retail investors, it feels like mutual funds have been a huge let down and haven't delivered returns.

This has resulted in a great number of investors questioning the value of having their money professionally managed. Here, we take a deeper look at equity mutual fund managers' earnings compared to the value they have delivered for investors.

Note: We're purely focusing on mutual funds that invest in stocks or a hybrid of stocks and bonds. These funds will be referred to as ‘Equity Mutual Funds' in this post. This analysis doesn't include bond funds or money market funds.

Mutual Fund Manager's Earnings

Mutual funds generate income from a few different streams, including:

• transaction costs for buying or selling shares of the mutual fund
• advisory fees
• marketing and distribution expenses

These fees are typically passed along to investors by funds taking a percentage of assets under management. These tend to range between 1% and 2% and, for equity mutual funds, have been on a steady decline over the past 20 years (see graph above). While this is good, the ratio of fees to the value mutual funds have delivered may be unbalanced.

From 2000-2010, equity mutual funds earned $603.53 billion in fees.

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Let's dig a little deeper by looking at the value that mutual funds have delivered for investors.

Investor Returns

In the graph on the right, you can see the returns that stock funds have delivered for investors from 2000 to 2010. In total, this resulted in an average return of 5.45% ($1,483 billion) per year, over this time period. We chose to look at this figure instead of the compounded return because individual investors often move from one fund to another.

The average return is actually pretty good considering that during the same period, the S&P 500 delivered a 2.34% average return per year. Now, let's compare the ratio of fees to returns to see if equity mutual funds returns are worth the fees that come with them.

Note: The equity mutual fund annual return is after management fees have been paid from the fund.

Are Equity Mutual Funds Worth it?

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On the surface, it seems like equity mutual funds are worth it, even if mutual fund managers are taking a lion's share of the returns.

However, the reality is that to take advantage of any market outperformance you would have to own a piece of every equity mutual fund out there. For the individual investor, that's nearly impossible and they'll never see those strong returns as choosing a fund that will consistently deliver is extremely difficult.

Caveat Emptor: Consistency is Tough to Find

The performance of individual equity mutual funds has hardly been predictable. In fact, 50-60% of equity mutual funds underperform the market each year (source). What's interesting about that is that it's not the same group funds that are consistently underperforming the market. It changes significantly year to year. This shows that a fund that's outperforming this year can easily be significantly underperforming the market next year. Therefore, it makes picking funds based on past performance an exercise in futility.

This is highlighted by Standard & Poors in their most recent Persistence Scorecard. The report [PDF] showed that only 9.72% of large-cap funds, 6.08% of mid-cap funds and 3.27% of small-cap funds consistently outperformed half of all the equity mutual funds over five consecutive 12-month periods.

This means that less than 10% of equity mutual funds were able to consistently outperform or get close to outperforming the market over a 5 year period. This is a very worrying picture as mutual fund investors often choose their funds based on past performance, when it's clearly not a reliable indicator.

The Verdict

On the whole, equity mutual fund returns have been strong, even with fees being high. However, retail investors most likely haven't benefited from these returns as the performance of individual funds have been inconsistent. As a result, they have every right to be frustrated and quite frankly, it shows that there's a broken system. It's no wonder ETFs are quickly becoming a large part of people's portfolios.

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