Monday, November 12, 2012

Losing Money with the Best Mutual Fund Manager of All Time


In a previous blog on averages, I used “average market returns” in my examples. In Stocks for the Long Run, Jeremy Siegel concludes that stocks have returned a nominal (not adjusted for inflation) compound rate of return of 8.3% a year over the past 200 years — the average market return.

In reality though, no individual investor earns “market returns” for very long, not even the best professional money managers.

The record for longest streak of outperforming the stock market belongs to Bill Miller.

Bill Miller managed Legg Mason Capital Management Value Trust fund to 15 consecutive years of outperforming the market. It is a feat that will likely never be repeated and that is far less than the 30 years you will have to invest for retirement.

What happened after this amazing 15-year stretch? Allan Sloan of Fortune magazine explained in a column he wrote in late 2011:

“When it comes to bad experiences, it's hard to top what has happened to Miller's investors since his hot streak ended in 2005. From Jan. 1, 2006, through this past Oct. 30, [2011] the last date for which average-investor results are available, his fund lost 7.40 percent a year; his average investor, buying high and selling low, lost 8.31 percent. By contrast, the average Vanguard index investor made 2.52 percent.
Thanks to the six-year underperformance, the return of the average Miller investor from the start of his streak in 1991 through October has fallen below the average index investor's return: 6.06 percent to 6.61 percent.”

All of those amazing years of market gains were given back rather quickly. Bill Miller is a legend among mutual fund managers, yet investors who stuck with him for his historical run actually underperformed the market. Why should you or I expect to do better?

Morningstar compares mutual fund investors’ actual returns to the fund’s return, and the fund’s return to market averages (indexes). Funds typically return less than the market, as the Bill Miller story exemplifies, but individuals earn even less than the funds in which they invest.

Mutual funds earn less than market averages primarily because they charge fees. Funds that charge its investors a 2% fee have to earn 2% more than the market just to match the market return. They also earn less because only a few money managers have the skill to earn more than investors should expect from random chance.

Investors, in turn, buy and sell funds at the wrong time and pay both mutual fund fees and taxes on their gains that further reduce their actual take.

According to Morningstar, from 2000 through 2009 the S&P 500 index returned an average of only 2.9% a year. The average U.S. equity fund, however, only returned 1.59%. As I said, most funds don’t earn as much as the market index. Finally, the typical investor in the U.S. equity funds earned only 0.22% a year for the reasons stated above, but primarily due to buying and selling at the worst times.

So, the market earned 2.9%. Your mutual fund shaved off 1% of your return by charging fees and making bad investment decisions, and you shaved off 1.68% by investing in the fund when stocks were soaring and then selling after they fell, leaving you a paltry 0.22% return per year over a ten-year period.

How does Morningstar know how much the typical investor earned? Mutual funds have to report cash in-flows and out-flows. Morningstar knows what the prices were when most people bought and when they sold.

A similar study determined that while the long-term average for the S&P 500 is about 8%, the typical mutual fund investor earns about 2.5%. They could have earned about the same in a money market fund with far less risk. Investors who try to time the market typically lose 2% a year.

When you look at a table of returns for various stock funds, the first thing you should know is that these amounts are what the funds earn. The typical person who invests in the funds earns significantly less.

Most retirement planning studies and strategies assume that investors will earn market average returns over the long run, but the evidence shows that most don’t come close.

Losing money in the stock market is not only possible, it’s highly likely. My retirement advice is that you not base retirement plans on long-term or “expected” market returns. Market returns are not your returns.

Before you invest, think about how losing that money might change your lifestyle. If you are unwealthy and need all your savings just to make ends meet then you shouldn’t invest in stocks, at all.

If your financial planner builds your retirement plan around the assumption that you will earn market returns for 30 years, she’s overly optimistic.

If “she” is you, I hope you’re a better money manager than Bill Miller.

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