What's Wrong With YOUR Mutual Funds' Performance?

Mutual funds are a hot commodity with individual investors and financial institutions. In fact, there are more mutual funds in existence than there are individual stocks -– that's almost 10,000 funds, for those of you taking notes. That amounts to more than $9 trillion invested in these things, just in North America alone.

With so much money riding on the success of mutual funds, how is it that 80% of them under-perform the stock market?

The answer is simple. A mutual fund is simply a collection of stocks and/or bonds. Mutual funds are financial intermediaries -- they are set up to receive your money and then make investments with the money. Most mutual funds are "actively managed," meaning the mutual fund shareholders, through a yearly fee, pay a mutual fund manager to actively buy and sell stocks or bonds within the fund. When you buy mutual fund shares, you are a shareholder -- an owner -- of that mutual fund, with voting rights in proportion to your ownership of the fund.

Though you would think that mutual funds provide benefits to shareholders by hiring "expert" stock pickers, the sad truth of the matter is that over time, the vast majority –- approximately 80% -- of mutual funds under-perform the average return of the stock market.

Why the underperformance? Are these MBAs in dapper suits the world's worst stock pickers or what? Did someone forget to carry a decimal? No and no.

Quite simply, the majority of mutual funds fall short because of the fees they charge you to be a shareholder. You pay for the privilege of active management. You pay for a fund's sales force, slick marketing, television ads, trading costs, and the fund manager's cloth-napkin business lunch and weekend cottage by the lake or the condo in Maui.

The costs of being in the average actively managed mutual fund over time are, put simply, very, very severe. The average actively managed stock mutual fund returns approximately 2% less per year to its shareholders than the stock market returns in general. That means that before your dollar even gets to the fund manager to invest, his company has already taken two cents off the top. And we won’t even speak about the poor performers.

Although 2% may not sound like that big of a deal when the market is returning roughly 20% per year as it did from 1995 through 1998, the standard returns for the stock market historically are closer to 10%.

Consider whether this is severe enough for you: over 50 years, a $10,000 investment will compound to $1,170,000 at 10% returns per year, but to only $470,000 at 8% per year. At 11% annual growth, $1 surrendered in year one is over $23 less for your retirement in thirty years. Add those dollars up, and you've handed over a lot of cash.

Most recently, the markets have had a lot of difficulty simply breaking even and with the subprime meltdown spreading its contagion globally, the extent and duration is still proving to be greater than anyone has envisioned.

An extended global market slowdown makes reducing costs during this period of static or negative returns even more important. Consider switching to funds with lower management expense ratios (MERs), such as index funds and exchange traded funds. These investments can be used to diversify and rebalance your investment holdings.