'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.

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