Why Mutual Funds are better than Index Funds

[midas]

You need to rethink you investment thesis and match the appropriate index to the mutual fund you are going to buy. If you own a mutual fund that is 100% large cap equity comp that against the S&P 500 index. Most older investors will start to move towards balanced funds that produce dividend income and slower growth (lower risk) which produces uncorrelated returns to the S&P 500.

Most mutual funds managers will try to closely emulate the index that they are comped against and rarely deviate from the underlying securities thus perpetuating the average performance of fund managers. In mutual fund world it's all about the management fees not stellar performance.

[player24]

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Most mutual funds managers will try to closely emulate the index that they are comped against and rarely deviate from the underlying securities thus perpetuating the average performance of fund managers. In mutual fund world it's all about the management fees not stellar performance.

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Be careful. Yes, the mutual fund management company earns fees based on assets under management, but the level of assets under management does vary, to some degree, based on the fund's performance. Fund's with strong performance tend to grow faster than Fund's with weak performance, and larger funds generate increased management fees.

Also, the portfolio management personnel at mutual fund companies usually are compensated based on peer group comparisons, not index comparisons. So, a small cap growth fund manager is probably compensated based on his ability to outpeform other small cap growth fund managers. In a given year, all of the managers may outperform (or underperform) the index, but only the managers who perform best will be rewarded...and the managers at the bottom of the ranking will often lose their job (after two consecurive years of underperformance, a manager is usually fired or on probation).

So, mutual fund companies are incented to perform well. And managers have strong incentives to perform well. And 'well' is generally defined by comparing one fund manager to another manager, not by comparing managers to indices.

And, yes, another key reason that funds underperform indices is that the funds are incented to preserve capital in down markets (as the original poster suggested).

[midas]

Interesting, I thought investors evaluated managers on their ability to outperform the no-brainer-low cost alternatives (indexes)which is quite different that how you characterize the internal grading system for a fund family. I guess that's why Stansky at Fidelity Magellan still has his job after underperforming the S&P index for all these years!!!

[OrangeCat]

player24 - Good post

adios - Keep on asking the tough questions.