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Where nearly everyone is below average: Investing in funds

NEW YORK (AP) - Welcome to where nearly everyone is below average.

It's the world where investors try to pick which mutual funds will beat the market. It sounds great in theory, but the odds of doing it successfully over the long term can be slimmer than winning a lotto prize.

Twice each year, S&P Dow Jones Indices checks how fund managers are performing against indexes in various categories. For the first time, it has a full 15 years of data to compare. That stretch of time captures not only two big rallies for the stock market (2002-07 and 2009 to today) but also the worst downturn since the Great Depression (2007-09), which means it should offer a look at the full breadth of a manager's skills.

Most funds did poorly relative to their index, and not just ones that focus on U.S. stocks, whose performance has been getting the heaviest scrutiny. The majority of bond funds and foreign stock funds also failed to keep pace with their indexes for the 15 years through 2016.

The natural reaction after seeing such numbers is to give up on funds that try to beat the index, and investors are doing just that, by the billions of dollars. But that may be confusing cause and effect a bit. More on that later. First, the numbing numbers:

For the kind of investment that forms the backbone of most 401(k) plans, less than 8 percent of funds that invest in stocks of big U.S. companies matched or beat the Standard & Poor's 500 index.

Success was even more elusive in other categories. The S&P 600 Growth index did better than all but one of the 175 small-cap growth stock funds available 15 years ago. That's a success rate of just 0.6 percent. Chances are better for winning one of the prizes in the Powerball game, where the odds are 1 in 25, or roughly 4 percent.

One big reason is that many funds simply disappear over time. More than half of all U.S. stock funds either merged with another one or shut down due to poor performance, lack of interest or other reasons over the 15 years of the study.

Another big reason is fees. Funds that charge high expenses must perform that much better just to match the index's return, let alone beat it. And while the cost of investing has been trending lower, hiring a team of managers and analysts to scrutinize corporate balance sheets still carries a price tag.

Of course, measuring the performance of mutual funds against indexes isn't entirely fair because indexes have zero costs, and no one can invest directly in them. But index funds and exchange-traded funds do exist, and they try to mimic the performance of indexes at costs that are getting closer to free.

Schwab has a fund that tracks the S&P 500 with an expense ratio of 0.03 percent, for example. That means $3 of every $10,000 invested goes to paying expenses annually. Many funds that try to beat the index have expense ratios above 1 percent.

That extra cost is close to the difference in performance between many actively managed funds and their benchmark indexes. The S&P 500 returned an annualized 6.7 percent over the 15 years through 2016, for example. Returns for large-cap U.S. stock funds were 1 percentage point lower, on average.

Investors have seen the difference in performance, and because of that have made index funds the hot trend. Nearly $638 billion poured into them during the 12 months through March, according to Morningstar. Nearly $310 billion left actively managed funds over the same time.

The split is most pronounced in stocks. The trend isn't as strong for bond funds, where both index and actively managed funds are drawing dollars.

Bond funds haven't been quite as bad as stock funds in keeping up with their indexes over the last 15 years, generally. Their performance has also been trending upward recently. Last year, 80 percent of intermediate-term, high-quality bond funds beat the index.

And bond fund managers say conditions are set for them to continue to do better than indexes because the Federal Reserve is raising interest rates again, helping to put an end to the decades-long march lower for bond yields.

Stock fund managers say similar things. Of course, they've been making the same argument for years, and few have been able to beat the market regardless.

Paul Greene is one of the outliers. He's the portfolio manager atop the T. Rowe Price Media & Telecommunications fund, which has returned more over the last 15 years than any fund that doesn't use borrowed money to juice its returns. His fund makes big investments in Amazon.com, Facebook and a few other stocks - more than half of his fund is invested in just 10 companies - that look set to grow at fast rates. He calls them "race horses," and he wants to hold them for years to let them compound, even if they have a temporary stumble.

"We may not win every race, but if that happens, I don't get off and shoot the horse," he says. "If we think we can keep winning races at an above-average level, we want to stay with it because it's really hard to win races."

The key, in the end, may be more about keeping costs low than in picking an index fund over one that tries to beat the market. It puts a lighter burden on a fund at the starting gate. Morningstar rates expenses at Greene's fund as low, for example.

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