It is commonly said that mutual fund managers can beat the market in one year, and maybe even two years. Over the long haul, however, any given mutual fund manager is certain to lose to the market, due to the higher-cost fee structure common with most mutual funds.
Other perspectives argue that mutual fund managers have little incentive to outperform. Given the marketing environment, it is better for the mutual fund manager to maintain performance that more or less equals that of the benchmark. That means investing the majority of a fund in the benchmark to be “close enough” every year. This also makes perfect sense, but given the egos on Wall Street, it doesn’t really seem to be that convincing.
So what if outperformance had nothing to do with fee structure or the fund’s marketing capacity? (This is a now commonly accepted mathematical finding following Nasim Taleb’s groundbreaking book Fooled By Randomness), but consider this additional cause:
Diversification Requirements Destroy an Edge
Mutual funds are governed by thousands of laws. Chief among them is the Investment Company Act of 1940 which sets the diversification requirements.
A mutual fund manager cannot:
- Own more than 10 percent of any one company.
- Invest more than 5 percent of the fund’s assets in a single holding.
These rules seem as though they’re for the betterment of everyone. Mutual fund companies never hold too large of a stake in one firm, which would allow it so much control that it could shift the balance in key decisions to parties not invested in the fund. A mutual fund manager with huge proxy voting power could easily shift influence for critical shareholder votes, and even install its own friendly associates on corporate boards.
The diversification rule also seems fair. The more diversification, the better for the investor – at least that’s what we’re led to believe.
Why Mutual Funds Underperform
These rules play heavily into the performance of any given fund. Here are just a few ways the diversification requirements place a hefty burden on managers looking to beat the market:
- Practical Indexing – Twenty stocks might as well be considered an index. Given that a mutual fund company must have at least 20 holdings by nature of the law, it is already fairly diversified to the point where the fund will begin to mimic the major market indexes. In this structure, the outperformers would necessarily have to be cut as the fund quickly runs over the 5% position limit.
- Small Cap Void – Mutual fund managers have to avoid small cap stocks to remain within the confines of the law. A mutual fund with $1 billion in assets could invest no more than $50 million in 20 different companies. This requires that every firm is also sized at $500 million in market cap or more, since fund managers can own no more than 10% of a single company. If you can invest only in mid and large cap stocks, it makes sense that you would perform in equity with an index like the S&P500 index.
- All Macro Plays – Mutual fund managers are required to be macro-theme investors. To place 10% of the fund into automotive stocks for a rebound, for example, a manager would have to purchase at least two companies. Basically, a fund manager is required to purchase both their perceived best investment and also their second best. Diversification obviously lowers returns. No rational investor would ever decide to invest in more stocks of lesser quality than fewer stocks of higher quality.
Paying for Expertise and Getting Nothing in Return
Imagine if by law, full-service gas pumpers in Oregon were required to service every car with one-third unleaded, one-third premium, and one-third super premium gasoline. Imagine that football coaches were required to let every player rotate as quarterback, and every baseball coach were required to make every player a pitcher to diversify their risk.
Imagine if your doctor were required to give you a proportional amount of every drug so as not to make any unnecessary risks in diagnosing and treating any common injury or illness.
Such laws would require those having the expertise to be above-average in their particular profession to be merely average.
Would you blame the gas attendant, the coaches, or the doctors for their inability to outperform?
Written by JT, who blogs about finance and investing at MoneyMamba.