The Little Book of Common Sense Investing, Updated and Revised

Chapter SevenThe Grand Illusion

Surprise! The Returns Reported by Mutual Funds Are Rarely Earned by Mutual Fund Investors.

IT IS GRATIFYING THAT industry insiders such as Fidelity’s Peter Lynch, former Investment Company Institute (ICI) chairman Jon Fossel, Mad Money’s James Cramer, and AQR’s Clifford Asness agree with me, as you may recall from Chapter 4. The returns earned by the typical equity mutual fund are inevitably inadequate relative to the returns available simply by owning the stock market through an index fund based on the S&P 500.

But the idea that fund investors themselves actually earn 100 percent of those inadequate mutual fund returns proves to be a grand illusion. Not only an illusion, but a generous one. The reality is considerably worse. For in addition to paying the heavy costs that fund managers extract for their services, the shareholders pay an additional cost that has been even larger. In this chapter, we’ll explain why.

Fund managers typically report the traditional time-weighted returns calculated by their funds—the change in the asset value of each fund share, adjusted to reflect the reinvestment of all income dividends and any capital gains distributions. Over the past 25 years, the average mutual fund earned a return of 7.8 percent per year—1.3 percentage points less than the 9.1 percent return of the S&P 500. But that fund return does not tell us what return was earned by the average fund investor. And that return turns out to be far lower. ...