Why do mutual funds underperform market

This shows that investors in the US have recognised the underperformance of actively managed funds vis-a-vis passively managed funds. In India actively managed funds have been underperforming their respective benchmark see table below. While Indian investors have had the opportunity to invest in index funds for over two decades, it appears that the underperformance of actively managed funds against passively managed funds has not caught the attention of investors. The AUM of index funds is a little less than 2 percent of actively managed funds.

The graph and tables below show the vast majority of actively managed funds are underperforming the benchmarks. As can be observed in the above table, active mutual funds across the three capitalisation categories have underperformed the benchmark returns. Out of 78 funds, 72 funds have underperformed the benchmark for a period of one year, that is a whopping 92 percent, and over a 10 year period 31 percent have underperformed see table below.

As against the under-performance of actively managed funds, index funds passive funds would have generated a return close to the benchmark as that is what they are designed for. Simply Save Know how to deal with unfair claim rejection. But why do index funds win? Index funds beat actively managed funds. This happens when stocks rise.

It happens when stocks go sideways. And it happens when stocks fall. An index fund that tracks the return of that market would have earned 5 percent before fees. Such fees might be as low as 0. Every actively managed dollar in that market would have earned 5 percent before fees as well. In other words, if we averaged what every day trader, every hedge fund manager, every actively managed mutual fund, every pension fund and every endowment fund earned in U.

Active traders cannot, as a group, beat the market because they represent that market. So, to beat a stock market index, an active manager must beat the aggregate return of their actively managed peers after fees. But to beat an index, the professional trader must beat the pre-fee aggregate return of other professional traders, even after deducting his or her fees. The first part is tough. Rules are fine, but when inflicted by a non-fund managing superior - they restrict the manager's freedom.

It limits his investment optionality and leaves out great potential opportunities that the manager could have taken in a less restrictive environment. For instance, the SEC says a mutual fund such as mine cannot own more than ten percent of the shares in any given company, nor can we invest more than five percent of the fund's assets in any given stock. As Buffet said: "Diversification may preserve wealth, but concentration builds wealth.

This forced diversification prevents the fund manager from doubling down on their winners and great bets. Moreover, with 20 holdings and actively looking for new ones - no single person can keep track of what's going on in the fund - making every decision be a decision by committee, which are known to be worse. So that's 0. Usually, it doesn't worth the hassle for such a fund. The incentives structure within a mutual fund is that everyone in the fund tries to minimize any short-term pain rather than make a good long-term play.

With results published quarterly and customers can retract their money at any point, if a manager or an analyst in the fund invests in something that goes down short-term, they are bust. So their quarterly results and possibly yearly results will look bad, making it harder to attract new investors.

You'll always prefer to make a safe bet that will at worst make you look just a little behind your competition rather than receive some short-term pain for long-term goals. After all, you make money by having investors paying you their fees. Not by making extra long-term returns for your investors. There has been an overwhelming growth in the number of investment choices over the last 20 years, as asset managers compete for investment dollars.

As a result, many investors are easily overwhelmed by the sheer volume of investments and confused about what investments they should have. The daily stream of events and the accompanying wave of pundit opinion can take its toll on weary investors and leave them in a state of angst about the markets and their investments. Planning is a powerful tool to help investors to refocus on their long-term goals and stay on track.

The chart below highlights the benefits of planning taken from a study on retirement planning among Americans over age 50 in a wide range of market conditions.