Statistics show that the over-whelming majority of mutual funds under-perform the general stock market index; a study found 78% of actively managed mutual funds lagged the Vanguard 500 Index fund (which tracks 500 large cap stock in the U.S.). Why? The explanation usually given is that mutual funds, even high-flying ones, eventually “revert to the mean” and perform just like the rest of the mutual fund sector. However, “reversion to mean” glosses over the structural issue that the mutual fund industry faces in matching or exceeding the general stock market indexes and gives further credence to the growing chorus of experts advising you and I to simply buy an exchange traded fund which tracks a broad based stock index(es).

The first structural issue is, quite simply, very relatable to anyone who works in a large organization. Large mutual funds work by committee and committees tend to make the safest decision and not the best one. When a mutual fund is small, the fund manager can still wrap their mind around what to invest in, when and for how much- the fund manager has a pulse on the industry. However, small mutual funds which do well become big mutual funds and, suddenly, the fund manager cannot look after the day-to-day operation of the mutual fund.

Investment committees have to be formed and, in my experience, most committees take middle of the road decisions rather than the correct one no matter how technically gifted the committee members are (the over-riding principle to such decision-making being CYA- cover your as*). Thus, big mutual funds become closet index funds- because that is the safe choice to make (and why pay the MER to have a closet index fund?)

The second structural issue is qualitative in nature. In the finance lingo, mutual funds don’t buy stocks, they take positions. When a small mutual fund takes a position, its position, in real dollars, is relative small (a small mutual fund may have under $1 billion of assets under management- remember we are talking about things being relative here; the largest mutual fund in the U.S., American Funds’ Growth Fund of America, has over $162 billion under management as of 2007). It can buy and sell without affecting the price of the stock being bought or sold greatly.

Now consider the plight of a large mutual fund (now we are talking about mutual funds with over $10 billion of assets under management) which we will call Acme Mutual Fund. Acme Mutual Fund has $10 billion assets under management (which would not even make into the 50^th largest mutual fund in the U.S.- not even close) and wants to invest a mere 2% of the fund, or $200 million dollars, to buy stock in ABC Co.

What effect do you think Acme Mutual Fund would have if it bought $200 million worth of stock at one time? Of course, the stock price would go up. To mitigate that effect, it tries to buy over time but you still have $200 million going into one stock over the short to medium term which tends to push the price up (or an enterprising investor finds that Acme Mutual Fund is taking a position and starts buying as well). In effect, the mutual fund is bidding against itself and buying positions for more than it should. Consider the Buffet effect- what happens when Buffet takes a position in a stock? It immediately goes up, making it harder for Buffet to add to his position at the same price.

Consider the other side of the equation, when Acme Mutual Fund needs to sell a stock/position. Now you have the opposite effect, you can’t dump $200 million worth of stock on the market without creating a drop in the stock price. Thus, you do the same thing again- you try to sell in dribs and drabs to ensure the stock price doesn’t fall completely. But, you have the same effect occurring. The market sees that there is a lot of selling going on and that supply exceeds demand in a stock meaning a drop in the stock price.

In effect, Acme Mutual Fund is getting in its own way; when it buys, the price goes up and when it sells, the price falls. It is getting the short-end of the stick both ways because it is a giant with clay feet.

Think about that the next time, an investment advisor recommends you invest in a large mutual fund because large mutual funds are safe. The Titanic was a big boat too.