You May Be an Index Investor and Not Know

NEW BERLIN, Ill. ( TheStreet) -- For those of you using actively managed mutual funds, I imagine one of the primary reasons is because you believe active management produces superior results. After all, these fund managers are smart guys and gals who spend their careers analyzing and picking stocks for their accounts. How can they not achieve superior returns?

Well, in practice, these superior returns don't occur as often as you hope. Too often (especially after a short stint in the limelight) the fund manager gets caught up in the short-term incentives so pervasive in our industry and avoids risky behavior. The incentive programs are typically geared toward meeting or beating the "average" -- generally defined as the applicable index. With that kind of incentive, the fund manager has a tendency to devolve any innovative processes and risky actions into following the index rather closely.
Funds promising large returns for your retirement are often no more than part of a classic investment firm shell game.

This doesn't happen to every fund, but probably to more than you think. Look at the life cycle of an active fund a bit more closely to understand what happens.

Under the covers
Mutual fund companies introduce lots of funds every year. As an example, let's say a fund company introduces 10, each with a fair-haired boy or girl managing it and doing his or her best to produce a superior return. Since these funds haven't been marketed to the public, the fund company often puts in some of their own money; called "incubation," this is a way for a fledgling fund to build a track record before investing a lot of money in marketing.

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.


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.