'Dumb' Investors Turn Out To Be Shrewd

NEW YORK ( TheStreet) -- Do investors buy the wrong funds? Plenty of academic researchers think so. The researchers say that many investors pick poor-performing actively managed funds. Instead of trying to beat the benchmarks with actively managed funds, most investors would do better by sticking with index funds, the academics argue.

But a new study by Morningstar suggests that investors aren't so dumb after all. According to the latest data, typical investors have achieved competitive results. "Investors have done a good job of picking active funds," says John Rekenthaler, Morningstar's vice president of research.

Rekenthaler says that the typical academic study looks at a group of 200 or so actively managed funds. Most often two-thirds or more of the funds failed to outdo their benchmarks during the previous 10 years. While the data in the studies may be accurate, the results don't necessarily reflect the experience of the typical investor, says Rekenthaler.

The problem is that most active funds have few shareholders and a tiny amount of assets. On average, the smallest funds have high fees and poor returns. In contrast, many big funds have low fees and high returns. The small funds only serve a limited number of investors, but the academic studies give equal weight to all funds -- regardless of their size. As a result, the dismal performance experienced by a small number of investors tends to reduce the average returns.

To appreciate the distortion, consider a simple study of the 10-year returns of the large blend funds tracked by Morningstar. Of the 353 funds with 10-year records, 149 surpassed the S&P 500 and 204 trailed the benchmark. By that measure the active funds appear to have failed investors. But many of the losing funds did damage to only a small number of investors.

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Among the poor performers was Concorde Value ( CONVX), which has $10.4 million in assets. The fund charges a fat expense ratio of 2.03% and trailed the S&P by 2.1 percentage points annually. Among the winners was American Funds Fundamental Investors ( ANCFX), which has $47 billion in assets. The fund charges an expense ratio of 0.64% and outdid the S&P by 2.6 percentage points annually.

Rekenthaler says that in order to get a realistic picture of how the typical investor fared, you should calculate the asset-weighted returns -- the average return of each invested dollar. That way you give more weight to large funds. Calculating the asset-weighted returns, Rekenthaler found that typical investors had been getting decent results.

On average the asset-weighted returns were higher than the returns recorded by weighting all funds equally. This suggests that investors are systemically selecting superior funds. "Investors have done better than if they had picked funds by throwing darts," says Rekenthaler.

According to the Morningstar data, investors have been gravitating to big funds with low expenses and strong returns. That has been a smart move. Because of economies of scale, big funds tend to have lower fees. The low expense ratios help the funds produce competitive returns. "The big funds are reasonably well run and cheaper," says Rekenthaler. "People are not doing major damage to themselves through fund selection."

Investors have proved particularly successful in picking small-cap funds. On an asset-weighted basis, small growth funds returned 3.98% annually during the 10 years ending in 2010. That topped the benchmark by 0.20%.

The asset-weighted results outdid the benchmarks in a variety of fund categories, including foreign large value, emerging markets and health funds. The active funds trailed in large growth and large value. Altogether the asset-weighted results outdid the benchmarks in eight of the 17 categories studied by Morningstar. In most categories where the active funds trailed, they lagged by small amounts. In general, investors in the active funds achieved results that were competitive with index funds.

In light of the Morningstar results, should you focus on big active funds? Not necessarily. The study makes clear that investors can get good returns with either active or passive funds of all sizes. But no matter which kind of fund you pick, it is important to stick with low-cost choices. Funds with low expense ratios enjoy an advantage that is hard to overcome.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.