Common Sense on Mutual Funds: Fully Updated 10th Anniversary Edition

Part III. ON INVESTMENT PERFORMANCE

Ultimately, we are concerned primarily with the performance of our investments. One of the investment principles least recognized by individual investors—reversion to the mean, that eternal force of gravity that seems to hold the financial markets in its grip—remains a fact of life in the world of investing. The fund industry ignores the subject, but my analysis shows that, whether considering the returns of individual funds or of different investment styles or of the stock market itself, superior returns finally revert to some sort of long-term norm. Very large mutual funds, once they have reverted to the norm, rarely rise again. The problems raised by the growth of this industry to giant size further compound the performance problem. Given the clear handicap of size, many large funds appear to have embraced "investment relativism," in which portfolios are structured to resemble the popular market averages, adding some stability to their returns, but at the expense of superiority—a costly prescription for failure.

Mutual funds routinely ignore taxes when they present their performance, but investors cannot ignore taxes. Yet most funds, apparently blind to the needs of their taxable investors, continue to engage in rapid-fire portfolio transaction activity, which generates excessive taxes without providing any apparent countervailing advantage, even to those investors who hold shares in tax-deferred accounts. I suggest several solutions to this ...