Morningstar gives stock picking funds terrible reviews

A rising tide lifts all boats, or so they say. That’s the inherent promise of indexing for retirement.

But an important corollary should be mentioned: A leaky boat sinks in any tide. Investment fund expenses will kill your retirement plan, no matter what kind of market is ahead.

That’s the takeaway from the latest study of mutual fund performance from Morningstar’s Russel Kinnel. He took a look at funds during 2008, 2009 and 2010, adjusting performance in order to find what he calls the “success rate.”

Success rate is an interesting idea. Simply put, it takes into account both the return and the continued existence of the fund in question. The industry doesn’t talk about this, but low-performing funds in time are closed down, their results erased from the record.

Imagine a baseball manager who fires all batters under .300 at the end of every game, all season, and then pretends with a straight face that his team batting average is made up solely of the players left standing. Cooperstown wouldn’t stand for it, but such thinking is normal on Wall Street.

Kinnel found in his latest study that, once again, fees strongly signaled outcomes, whether the market was gently rising or in a period of significant transition. The lower the fees, the better the return — bear or bull market, growth market or value market, in his words.

The cheapest funds killed it and the priciest funds lagged, as Kinnel found in an earlier study. For domestic stocks, choosing low-cost funds effectively doubled your success rate in 2008. For foreign stocks, balanced funds, taxable bonds, municipal bonds and so on the gap was consistently wide.

In 2009 and 2010, as markets bottomed and then soared higher, the pattern continued. To quote Kinnel:

Vanguard founder Jack Bogle has pointed out that markets don’t have to be efficient for low costs to work. We know that mutual funds as a whole will get roughly the market’s return minus fees and trading costs. Those that charge less are naturally more likely to outperform than those with high costs.

Put more bluntly, active management are less than worthless. The idea that you need an “agile” manager when markets are moving is unsupportable. The dividing line between okay returns and great returns is cost, plain and simple, in any market.

So why not buy an index fund and be done with it? Well, some people like the idea of having a financial advisor. They need, perhaps, a guiding hand who will start them off in an age-appropriate, well-designed portfolio and then rebalance it with discipline. They need, maybe, a voice of reason who will keep them from selling it all in a market decline.

Beware stock pickers

What people do not need, and Kinnel’s data shows it, is a stock picker, someone who purports to be able to “beat the market” by selecting a small number of securities and then actively trading that portfolio ad nauseam. A balanced portfolio of cheap index funds or index-style ETFs would do better.

First of all, stock pickers can’t beat the market consistently enough to matter. Second, if they do beat their benchmark once and again, they don’t beat it by enough to justify the fees they charge year in and year out.

Third, and most importantly, the active manager is very unlikely to provide anything like personal financial advice. Most active managers live in a bubble far away from the crowds of actual flesh-and-blood clients. You hear from them primarily in dry quarterly mailings.

Forget getting a phone call and forget having a portfolio crafted to meet your retirement needs. Just leave a voice-mail, since he’ll likely be busy swimming in his violin-shaped pool

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