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May 1, 2015

Should you buy mutual funds from your bank?

Many investors are cautious when it comes to in-house mutual funds being offered by banks. Is that caution justified?

Evidence versus marketing

According to a study by Morningstar done for the New York Times, most of the funds run by each of the four largest US banks (Goldman Sachs, Morgan Stanley, JP Morgan Chase and Wells Fargo) have underperformed their benchmark over the last 1 and 10 year period. Over the more meaningful 10 year period, the percentage of mutual funds from these four banks performing better than their index was only 12%-38%. A similar study on the performance of the German in-house mutual funds showed comparable results.

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Running in-house mutual funds is clearly a good business for the banks, but not necessarily a good investment for the client.

Vanguard’s actively managed mutual funds are coming out on top in this study, both over the 1 year and 10 year period. Interestingly, they are not winning so consistently because the others are so bad at investing but because of Vanguard’s low costs (right column). Morningstar found in another study that cost was the ONLY statistically robust determinant of future performance.

The real question for investors is why they should be in actively managed funds in the first place, if they cannot beat the benchmark. Funnily enough, some banks even acknowledge the difficulty that their mutual funds have in outperforming lower-cost alternatives like ETFs. A report distributed by Morgan Stanley to its financial advisors (not its clients!) said so much: „aggregate long-term performance and fees both favor passive over active“ management.

A better mouse-trap

By now it should be no secret why passive investing is superior to buying more expensive active funds: investors collectively receive the market returns MINUS the costs of the fund-type they invest in. Typical all-in costs of actively managed funds are 2-3% p.a while they are less than 0.5% for most ETF. Though there are always some funds that beat the market, it is virtually hopeless to identify them ex-ante. In my previous work at Credit Suisse, I covered many of the largest global asset managers and Hedge Fund managers for 15 years and I had to come to the conclusion that it is nigh on impossible to work out who is going to outperform the rest on a consistent basis. Investors who think they can buy actively managed funds that can stay consistently in the top quartile (not even asking for consistent outperformance!) are fooling themselves. A recent study has shown that only 0.07% (!) of actively managed mutual funds managed to stay in the top 25% over four years running. Identiyfing those 0.07% ex-ante is really not a question of skill but luck. While it certainly is possible to win the game of active management, the odds are so poor that it’s not prudent to even try

Summary

The hard evidence is there for everyone to see. Why then are people still investing in actively managed funds if empirical evidence is so clearly showing that this is not the best option long-term? First because many advisors have a financial incentive in selling mutual funds and not ETFs. Second, it is also a matter of shifting the psychological responsibility of managing wealth to another person. Active mutual funds give that illusion. ETF don’t provide that. Banks and advisors who sell these mutual funds know it – and therefore get away with not recommding the best possible product. Don’t make the same mistake.

Time and again the big banks have proved themselves the worst active managers, but still they attract large inflows. Marketing and distribution power trumps hard evidence. We can show you how to turn the undisputed benefits of low-cost investing into your advantage.

If you think we can help you with your portfolio and financial planning, please get in touch here.

 

Sources:
http://www.nytimes.com/2015/04/13/business/dealbook/wall-street-banks-mutual-funds-can-lag-on-returns.html?_r=0
http://www.faz.net/aktuell/finanzen/fonds-mehr/wertentwicklung-viele-deutsche-fonds-taugen-nichts-12902479.html
http://www.morningstar.com/cover/videocenter.aspx?id=693121
http://www.indexologyblog.com/2015/04/23/spiva-interpretation-and-misinterpretation
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