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I had a call with a friend who wanted my take on investing in Mutual Funds. He reeled off the 1- and 3-year returns on a few funds, all showing stellar multi-year CAGR of 30%+. My take is that I'm forever cynical of mutual funds because I know basic statistics and the game being played by the big mutual fund houses.
Say a big mutual fund house launches 200 funds run by 15 "portfolio managers". Each fund having different rules, styles, list of allowed investments and position sizes, etc. Some funds gather AUM, some funds fail to gather AUM and are collapsed into the more profitable funds. By profitable, I mean profitable for the fund house - which is defined as a fund having enough AUM to generate a fat management fee. Over a period of time, the fund house keeps launching and collapsing funds. The marketing department picks up the prospectuses of the funds showing good gains and passes them on to the sales force. Mutual fund sales is a whole other ballgame. Salesmen are compensated based on the assets they gather. No part of their compensation structure is deferred and linked to the subsequent performance of the funds they sell.
The salesmen have every incentive to push the easy sale - the funds which show a demonstrable track record of great multi-year returns. Investors are fooled by the track record, and when they realize in a few years that the funds they invested in didn't live up to the hype, they don't connect the dots. They simply switch to the next batch of funds marketed by the snake oil salesmen. The salesmen, all sympathetic and apologetic for getting the investor into the fund he thought was the best, pushes the next sure thing. The fund house retains the unhappy investor's money, the salesmen make their commissions, and the merry racket continues.
The fortunate folks who actually do manage to pick the top funds are also trapped, in a way. They attribute their performance to their superior selection skills, and stay in the mutual fund game hoping to repeat their past success.
However the individual funds perform, the fund house and sales force come out on top. The investor has been convinced by financial media (guess who pays them for advertisements?) that buying and holding stocks for the long run is the best strategy, so he sticks to investing his savings in mutual funds regardless of performance. If he does make money off his investments, that's only incidental.
But, but, but... what about the skill of the portfolio manager? Try asking the mutual fund salesman whether there has been a change in the portfolio manager of the fund they are pitching. They wouldn't even have that information. But let's say they inform you that the same manager has run the fund for the past 10 years. Follow up by requesting information on all the other funds that portfolio manager is responsible for and the track record of those funds. You'll never hear back from the salesmen, because that questions signals that the game is up and you're no longer the easy mark he was expecting you to be.
If you want to be even more of a curmudgeon, ask the fund house for the full list of their funds 3 years ago, and the 3 year track record of those funds at that time. Study that list and see for yourself whether you'd have managed to pick today's winning fund from that list. Chances are slim to none, and slim left town.
Don't be fooled by the mutual fund prospectus, it's all merely survivorship bias. When they tell you that past performance is no indicator of future returns, they really, really mean it. They tell you that's just a legal disclaimer, but it's not. It's the only absolute truth you get from the industry.
Good Trading!
Kashyap