NEW YORK (MainStreet) — Playing the lottery is rarely a good retirement strategy. But investors seeking long-term, out-performing mutual funds are playing the same odds. Research Affiliates, an investment management company in Newport Beach, Calif., crunched the numbers and came to a dismal conclusion: you've got a better chance of winning a cash prize from a Powerball lottery ticket than you do in selecting a winning mutual fund money manager.
The firm researched funds that beat the market by 2% or more over a 45-year period. Out of an initial 358 funds, only 45 survived the long-term timeframe and outperformed the S&P500. But only three mutual funds had an excess return of 2% or more. Just three. That means investors are facing some mighty long odds in seeking a winning fund.
"This suggests that the odds of identifying a long-term superstar who outperformed by two or more percentage points is a mere 0.8%, a 1-out-of-119 chance," John West, managing director and head of client strategies for Research Affiliates writes in an analysis. "With these odds, you actually have a slightly better chance of collecting a cash prize on the multi-state Powerball lottery -- not the Mega Millions Grand Prize, but still a payout!"
Now West admits, 40 years is a long-term time horizon, but not unreasonable. "For instance, 30-year-old workers picking a standard target date fund could have a substantial equity allocation of 90% until age 55 and a still sizeable 30% once they reach 85 years," he says.
The implications are considerable. A buy and hold strategy for mutual funds is practically impossible, at least for the very long-term. Investors will need to monitor the performance of their actively-managed mutual funds – and have a great deal of patience.
"Even the most extraordinary long-term performers will spend a significant time trailing benchmarks (and, often, enough time to look downright incompetent)," West says. He notes that even for the superstar handful of overachieving funds they identified, the longest stretch of three-year underperformance would have lasted 23 quarters -- over five years. By that time, most investors would have thrown their hands up in disgust and sold out their shares.
Perhaps a better solution would be to opt for passive, market-index funds that simply aim to equal market returns.
--Hal M. Bundrick is a Certified Financial Planner and contributor to MainStreet. Follow him on Twitter: @HalMBundrick