Mutual funds tend to underperform in comparison to expected benchmarks, suggesting that fund managers may be better off relying on market prices instead of trying to find opportunities in what they perceive to be mispriced securities, according to a new report from Dimensional Fund Advisors.
“We believe the research highlights an important investment principle: the capital markets do a good job of pricing securities, which intensifies a fund’s challenge to beat its benchmark and other market participants,” the report read. “When fund managers charge high fees and trade frequently, they must overcome high cost barriers as they try to outperform the market.”
The report found those funds with high costs and fees tended to underperform. For equity funds in a 20-year period through December 31, 2018, 37% of funds with a low expense ratio were "winners" (defined as funds that survived and outperformed their benchmark), while 63% were "losers." For 20-year equity funds with a high expense ratio, the contrast was more striking, with 11% designated as winners compared with 89% as losers.
Both equity and fixed income funds with longer horizons tended to have more losers, with the report suggesting that cost burdens over a longer period of time would make it more difficult to perform. Investors may be responding to this trend; a Morningstar study released last year showed that investors were paying less than ever to buy into mutual funds and ETFs, due in large part to more demand for passive investments.
Though there were 4,576 total U.S.-based mutual funds as of December, many do not survive over time; the report found that more than half of all equity and fixed income funds had disappeared during a 20-year time period (23% of equity funds and 8% of fixed income funds survived and outperformed their benchmarks during this same period, according to the report). Noting how many funds disappear can offer a more representative understanding of funds and can avoid survivorship bias.
The report was generated from analyzing mutual fund data from Morningstar, with index funds and funds-of-funds excluded from the sample.