The private retirement system in the United States is built on mutual fund investments held primarily within employer defined-contribution plans and individual retirement accounts. Mutual fund investors in the United States have been tasked with choosing the funds that constitute their retirement portfolio. More than two decades of academic studies and experience come to a consistent finding: by and large, these fund investors are not up to the task.
These conclusions come from a chapter for an upcoming handbook on mutual funds (by Edward Elgar Publishing). The chapter offers an overview of the mutual fund market and the investors who inhabit it. On the supply side, mutual funds hold $16 trillion in financial assets and have become the largest component of our private retirement system. On the demand side, mutual fund ownership has become widespread, with 90 million fund-owning households composed mostly of middle-class, educated, and older investors.
The portrait of mutual fund investors, painted by a large and consistent body of academic and government studies over the past few decades, is disturbing. Fund investors are mostly ignorant of their funds’ characteristics, inattentive to risks (and opportunities) of different asset classes, and often insensitive to fund fees. Instead, fund investors tend to chase past returns, regularly buying high and selling low. They also, like many investors, often attempt unsuccessfully to out-guess and time the market. As a result, the average returns for fund investors (both in stock and bond funds) have significantly trailed benchmark market returns – according to some studies by between 2.4% and 5.3% per year, depending on the time period studied.
To illustrate the significance of this gap, a fund investor investing $5,000 per year for 20 years in a low-cost US equity index fund (assuming annual fees of 0.2%) would have at retirement an investment portfolio that grew to about $302,000 (compared to $309,000 for the overall US equity market). Instead, actual returns for the average investor in managed equity funds (still the largest segment of the US mutual fund market) would have resulted in a retirement portfolio of about $177,000 – a shortfall of nearly 40%. For fund investors who invested over longer periods, such as 40 years, the shortfall reaches a staggering 70% of what a low-cost fund would have produced, compared to actual returns in a typical managed equity fund.
Where are the professionals? Studies on the role of financial intermediaries in the mutual fund market have also been disconcerting. Often, financial advisers give fund investors conflicted advice, leading them to choose high-cost, under-performing funds on which the advisers garner commissions. Although some employers are shifting employees to low-cost, risk-appropriate balanced funds, many 401(k) plans remain less than optimal. Moreover, fund companies tout higher-cost actively managed funds, despite growing evidence that most, if not all, fund managers are unable to beat the market – particularly after fees.
There are, however, glimmers of hope. Recently, many fund investors have moved to lower-cost index funds – reflecting a new sensitivity both to the importance of low costs and to the empty promise of active fund management. As of 2016, index funds represent 22% of the assets held in US equity mutual funds, with fund investors over the past decade moving $1.2 trillion to passively-managed index funds, while withdrawing more than $800 billion from actively-managed funds during the same period. In addition, target date funds have established a beachhead in the 401(k) market, more than tripling their assets under management in the past decade. The recent clarion calls of the financial press reinforces these trends, as a growing drumbeat of stories emphasizes the importance of fund fees, the counter-productivity of trying to beat or time the market, and the emptiness of chasing past fund performance.
Alan R. Palmiter is the Howard L. Oleck Professor of Business Law at Wake Forest University, School of Law.