Most people reading this article will have some experience with mutual funds. Whether part of your IRA, 401(k), or other savings vehicle mutual funds play a key role in helping people achieve their savings goals with access to a wide variety of companies and diversification along with professional management.
By professional management we mean an individual or team of managers that run the day-to-day activities of the fund such as buying and selling of stocks and bonds as well as running financial analyses of the different companies whose stock they are looking at adding to or selling from the fund.
Mutual funds and their managers vary and from the macro level you essentially have two types of managers – active and passive. Active management means that the managers of the fund actively trade securities in hopes of achieving higher than market returns or outperforming their respective benchmark, such as the S&P 500. Passive manager have more of a buy and hold mentality and will rarely trade unless it is absolutely necessary or if they are index fund manager and a specific company had been added to or removed from an index such as the S&P 500.
What they won’t tell you is that many fund managers will often play monkey see monkey do. Fund managers will mimic what their counterparts are doing and buy and sell the same funds. Rarely will you see a manager go out on a limb – there’s too much to lose such as a well-paying job, and a sizeable bonus.
Studies have shown that managers will “hug” their respective benchmarks for job security – meaning that rather than try to beat their benchmark by a wide margin, they will stay within a few percentage points, plus or minus in order to still meet their goals. A manager the consistently beats the market by a wide margin will be expected to do the same year after year – a feat impossible to do over the long run and in the short run, mostly due to luck.
Admittedly, there will be some managers that will beat the market. You’ll see them announce their victories in the different financial press showing stellar returns and how their fund beat the market. Read the fine print. In most cases they will be announcing their returns before expenses, called gross returns. Look at net returns, after expenses, and the same managers have now underperformed the market or their benchmark. And if they’ve been lucky enough to really beat the market by a wide margin, in most cases the next year the fund is scraping the bottom of the barrel.
In the long run your best bet is to simply buy and hold the market through passive management and index funds. Your expenses are less and you’re not paying someone to do something they can’t.