Why mutual funds underperform the market?

4 top reasons according to Peter Lynch

July 25, 2021

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More than 75% of mutual funds underperform the market. This figure is moving on a year-by-year basis but remains very high regardless. The failure of mutual funds has more to do with the structure of mutual funds than an inherent issue with active investing as a whole - as I covered in a previous article.

Unraveling the reasons behind the mutual funds' failure can help us as individual investors understand what we can do better to perform well in the markets.

To drive the points forward, I'll use quotes from Peter Lynchs' book "One up on wall street". Peter Lynch is a legendary mutual fund manager, leading the Magellan fund to have more than 29% average annual returns. Not only that he understands the mutual funds' limitation intimately by working in and managing one for decades - but he understood them so well as to escape them and perform extraordinarily in his fund. So he is probably the best resource on the matter.

Rules and regulations

Restrictive rules on how to invest and what to invest in are disabling any fund manager from employing his strategy freely. Sometimes, those rules are so restrictive that you wonder what kind of decisions are left for the manager.

Internal rules

Almost every mutual fund has an institution or a manager above the fund deciding on how the fund should invest. Usually, this is the owning bank or the union holding the pension fund or something similar.

Peter Lynch wrote in his book: "Some bank trust departments simply won't allow the buying of stocks in any companies with unions. Others won't invest in nongrowth industries or in specific industry groups..."

He then describes weirder and more restrictive rules, such as investing only in certain weathers or companies with names starting with certain letters.

Rules are fine, but when inflicted by a non-fund managing superior - they restrict the manager's freedom. It limits his investment optionality and leaves out great potential opportunities that the manager could have taken in a less restrictive environment.

External rules - Government regulations

Peter Lynch wrote: "If it's not the bank or the mutual fund making up rules, then it's the SEC. For instance, the SEC says a mutual fund such as mine cannot own more than ten percent of the shares in any given company, nor can we invest more than five percent of the fund's assets in any given stock."

Lynch is referring to the 75-5-10 regulation here. This regulation determines that:

  • 75% of the fund must be invested in other issuers
  • No more than 5% of the fund be invested in a single entity
  • You can't hold more than 10% in a company

These rules force you to both diversify and avoid small companies, depending on the fund size.

With a maximum of 5% of the fund invested in any single entity, that means that a fund should hold at least 20 assets. As Buffet said: "Diversification may preserve wealth, but concentration builds wealth.". This forced diversification prevents the fund manager from doubling down on their winners and great bets.

Moreover, with 20 holdings and actively looking for new ones - no single person can keep track of what's going on in the fund - making every decision be a decision by committee, which are known to be worse.

As to the maximum 10% holdings of a company, imagine a $10B fund - for small-cap stock with a market cap of $500M, they will at most buy $50M. So that's 0.5% of the fund. Usually, it doesn't worth the hassle for such a fund.

Playing it too safe

The incentives structure within a mutual fund is that everyone in the fund tries to minimize any short-term pain rather than make a good long-term play.

With results published quarterly and customers can retract their money at any point, if a manager or an analyst in the fund invests in something that goes down short-term, they are bust. So their quarterly results and possibly yearly results will look bad, making it harder to attract new investors.

You'll always prefer to make a safe bet that will at worst make you look just a little behind your competition rather than receive some short-term pain for long-term goals.

After all, you make money by having investors paying you their fees. Not by making extra long-term returns for your investors. (For the most part).

Some of Peter Lynch writings on the matter:

  • "The fund manager most likely is looking for reasons not to buy exciting stocks.."
  • "There's an unwritten rule on Wall Street: "You'll never lose your job losing your client's money in IBM.""
  • "If IBM goes bad and you bought it, the clients and the bosses will ask: "What's wrong with that damn IBM lately?" But if La Quinta Motor Inns goes bad, they'll ask: "What's wrong with you?""

Following trends

Part of "Playing it safe" is avoiding original or in any way special moves. If you follow what everyone else is doing - you'll get what everyone else is getting. And that's great for the mutual fund manager - that means he won't have his clients running out of the fund.

Peter Lynch wrote: "They don't buy Wal-Mart when the stock sells for $4, and it's a dinky store in a dinky little town in Arkansas, but soon to expand. They buy Wal-Mart when there's an outlet in every large population center in America, fifty analysts follow the company, and the chairman of Wal- Mart is featured in People magazine as the eccentric billionaire who drives a pickup truck to work. By then the stock sells for $40."

Size

The last issue is size. Mutual funds usually manage massive amounts of money - which is hard to manage. Peter Lynch wrote: "My biggest disadvantage is size. The bigger the equity fund, the harder it gets for it to outperform the competition."

Harder to find opportunities

The bigger the fund is, the more companies it rules out from being a potential investment. Especially in terms of potential capital to deploy - in tandem with the 75-5-10 regulation mentioned before.

Holding at most 10% of any company rules out more and more potential holding as the fund is growing bigger.

Hard to change positions

Once you are big enough, your movements within a single stock can affect the price in and of itself. Thus, making you less agile and less able to sell bad picks or buy great opportunities on a whim.

An example of that is the case of Coca-Cola and Warren Buffett - he mentioned he didn't sell when it was overpriced because his holdings were too significant, that if he tried to sell, the price of the stock would slash massively.