Lessons from Proprietary Mutual Fund Returns

US News

I am fascinated by the success of the securities industry. They are able to convince you to part with your money by touting their expertise in managing it. They claim to have skills that don't exist, like stock picking, fund manager selection, and market timing. No matter how often they are wrong, and no matter how much you lose by following their flawed advice, investors persist in the belief that someone has these skills. Investors go from one broker to the other, in search of an investment guru who can predict the unpredictable and add "alpha" (returns above a designated benchmark index) to your portfolio.

Persuading you they have this expertise is critical to the viability of their business model. They know you have an alternative. You could purchase a globally diversified portfolio of low-management stock and bond index funds directly from major fund families like Vanguard, Fidelity, T. Rowe Price, and Charles Schwab. By doing so, you would capture market returns at a much lower cost. Brokers often deride index-based investing as being for "amateur investors" who don't have access to sophisticated brokers (like them).

The data tells quite a different story. Over the past 20 years through December 31, 2011, the average stock individual investor (presumably guided by their broker) had an annualized return of 3.49 percent, according to a study by Dalbar. During the same time period, the S&P 500 Index had an annualized return of 7.81 percent. That's quite a difference. Brokers added "negative alpha" to these investors.

Brokers are very adept at trivializing this data, so I have come up with an inquiry that should put the issue of their purported expertise to rest. I ask them about the performance of their proprietary funds. Presumably, if they have the expertise to pick fund managers who will outperform their benchmarks, they should be able to convey this methodology to the fund managers of their own branded mutual funds.

Representatives of Wells Fargo caught my attention when they advised a prospective 401(k) client of their ability to select "winning" fund managers. I ran an analysis of the "Wells Fargo Advantage Funds" (its proprietary funds) for the ten-year period from January 1, 2002 to January 31, 2012. I found that 64 percent of these funds underperformed their Morningstar-assigned benchmark during this period.

It's sad that so few plan sponsors have access to this data, which they could use to challenge the bold claims of brokers who regale them with their ability to add value. If they did, they would reject these entreaties as puffery, insist on data supporting the ability to predict the unpredictable, and banish all actively managed funds as investment options in their 401(k) plans. That's the kind of reform this system needs.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.



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