You May Be an Index Investor and Not Know

At the end of the year, nine of the 10 funds have underperformed, but one outperformed the indexes by a wide margin -- let's say by more than 20%.

The nine poor-performing funds are eliminated, perhaps merged with the winner to bolster its asset size. Then the marketing begins. Investors hoping for that "one in a million" investment are drawn to this new, fair-haired investment manager because of the fantastic return her guidance produced in the past year.

The interesting part
So what happens after the fund has had its initial "home run" season, where it outperformed the market by 20% or more? The fund attracts all kinds of attention and investors. In the second year, lots of money pours in, and the manager does her best to reproduce a return superior to the benchmark, like the previous year. Amazingly enough, she does it, but this time only by about 2% overall -- and the expense ratio of the fund eats 1% right away. But look at her track record: Over the span of two years, she's outperformed the index by an average of 11%! Why would you not invest in this fund?

After the second year where the manager just squeaked out a positive result, not wanting to lose investors' funds she becomes more conservative -- more closely tracking the index against which her fund is compared, rather than whatever magic was used to produce the first year's stellar results. At the end of this year, the fund doesn't quite meet the index's return, but it's pretty close (until you take out the additional 1% of expenses). But again, the marketing slicks point out that, over a three-year period, this manager has outperformed the index by almost 7%. Again, you'd be a dummy to not invest with that kind of result, right?

And so it goes. Eventually this fund's returns are near the index each year, and after a run of several years the fund is folded into the next best thing. Lather, rinse, repeat ... As I said, certainly this doesn't happen to every managed fund out there, but it probably happens more often than you think.

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This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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