From 1950 through 2009, the average annual return on S&P 500 stocks, before accounting for inflation, is about 11 percent. An S&P 500 index fund comes very close to matching this return by investing proportionately in the same stocks. A mutual fund attempts to beat this index by selecting outperforming stocks. But, in reality, most mutual funds don't as well as the S&P 500 index. About two out of three have investment returns lower than the overall market average. Individual investors do much worse.
At first glance, finding a fund that beats a benchmark like the S&P 500 doesn't seem that difficult. One approach is to set up a mutual fund screener that captures all large-cap stocks -- companies with total shareholder values of more than $10 billion -- with superior performance. A search in the mutual funds research section of an online brokerage initially finds about 4,500 large-cap mutual funds. Screening for only those large-cap funds that had beaten the S&P 500 benchmark every year for the past 10 years, and further screening to eliminate any fund with less than 25 percent annual one- and three-year returns, less than 15 percent annual five-year returns and less than 10 percent annual 10-year returns, returns five funds. Looking at this from another perspective: All but five of 4,500 funds did not perform this well.
Five Great Funds
While these five large-cap funds all beat the S&P 500 index over a 10-year period, only four of five beat the 11 percent annual index return over the longer period, 1950 to 2009. The fifth, a Fidelity fund specializing in retail multimedia sales, returned 10.08 percent annually over the 10-year period 2003-13, about 1 percent less than the long-term index. Significantly, all five funds were sector funds: three biotechnology funds, one multimedia fund and only one relatively broad spectrum fund, a Fidelity consumer cyclical. The specialization of these funds is significant because while, in retrospect, 2003 to 2013 was a very good period for all of them, particularly the three biotechnology funds, this doesn't mean that the 10 years to follow will be equally good.
The Odds Against the Right Guess
When you select a broad fund, like an S&P 500 index fund, you aren't trying to beat the average, only to approximate it. Your odds are good, but selecting specialized funds in sectors that will outperform dozens of other sectors over the next 10 years is a little like throwing darts in the dark. You might hit a bullseye -- the right fund sector -- but the odds are you won't. Statistically speaking, out of approximately 4,500 large cap funds, about two out of three underperformed the index.
The Persistence Problem
Another problem with picking funds with outstanding past performances is that the odds are against their being outstanding in the future. An S&P study of performance persistence shows that only about 6 percent of large-cap funds with a top-quartile performance ranking over a five-year period were able repeat the performance over the following five years.
The Bottom Line
These disappointing performance statistics suggest that investors should not see the 11 percent long-term average annual mutual fund return as a number to beat. Rather, it proposes a very high goal -- one that most investors fail to reach. Worse yet, once inflation is accounted for, that 11 percent average shrinks to about 7 percent.
I am a retired Registered Investment Advisor with 12 years experience as head of an investment management firm. I also have a Ph.D. in English and have written more than 4,000 articles for regional and national publications.