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Fees. The fund industry never met a fee it didn't like. There are management fees, 12b-1 fees, custodial fees, transfer fees, accounting fees, directors' fees and professional-services fees, to name the most common. This litany of levies, assessed each year, typically totals 1.4% of assets in a fund and reduces the return by roughly that amount. And that doesn't include the impact of one-time sales charges of up to 6%. Such "loads" aren't reflected in official performance data but are a cost that cuts into your results.
Turnover. In the typical stock fund, 4 out of 5 stocks held at the start of the year are gone by the end of the year. The trading costs subtract an additional .6% from a fund's investment gains.
Cash. The typical fund keeps 7% to 10% of its assets in cash, a stash to pay off investors redeeming shares. That part of the portfolio is a drag on performance when the stock market is hot.
"The costs eat you up," says John Bogle, a low-fee fanatic and chairman of mutual-fund company Vanguard Group, which champions "index funds" as the surest road to long-term investment success. Over long periods, Bogle says, it's inevitable that managed funds will trail the benchmarks by roughly 2 percentage points a year, reflecting their costs. But index funds such as Vanguard's Index 500, which mimics the S&P 500 by owning essentially the same stocks, have low fee structures and allow individuals to easily approximate the market's average return year after year. Last year the Index 500 rose 22.86%; the S&P 500, 22.95%. Over 10 years, the Index 500 has risen an average annual 15.04%, just behind the S&P 500 index gain of 15.29%. Meanwhile, the average general stock fund has been lagging: 19.4% last year; 12.5%, on average, each of the past 10 years. Historically speaking, those returns are phenomenal. But next to the average returns easily available through index funds, they pale.
Last year's results suggest the gap is widening, indicating that something more than fees is the problem. Ironically, no one seems to pin it on the influx of thirtysomething fund managers hired as part of the industry's explosive growth. "In a bull market like this, youth is an asset," argues Michael Lipper, president of Lipper Analytical. The young have no recollection of, and thus no fear of, a declining market. That translates into being fully invested and having got the most out of stocks during this exceptional rally.
So what does account for the widening gap? When stocks are flying as they are now, even discerning managers blindly plow money into the big stocks that make up major indexes. They want to hold little cash so it doesn't drag down performance. But the cash comes into their funds so fast that they can't find enough lesser-known stocks to spend it on. So they park ever more money in big stocks, which are easy to buy and sell, while searching for true bargains.
That behavior tends to drive up the indexes and leaves fund managers reluctant to sell their big stocks, which are rising. The end result is that large stocks take off, and the lesser-known stocks in most funds--the ones being counted on to provide the most kick and produce superior results-- instead hold the funds down.