THE TRUTH ABOUT MUTUAL FUNDS: They Can’t Pick Stocks Either

If there’s one piece of financial advice that most people agree on it’s that individual investors should buy mutual funds.


Because the mutual funds do the work that individual investors don’t have the time, skill, or money to do: Figure out which stocks are good and which stocks are bad and invest your money accordingly.

But that’s a false promise, says Mark Hebner, who is CEO of a $1.5 billion asset management firm called Index Funds Advisors . The vast majority of mutual funds do worse than index funds. As a result, they cost their investors money–both from high fees and reduced returns.

The fundamental flaw in most mutual funds, Hebner says, is that even well-educated portfolio managers with huge research budgets can’t pick winners consistently enough to beat the market over time. Yes, by the luck of the draw, about a third of mutual funds will beat the indices each year. But last year’s winners are often this year’s losers. When you look at long-term performance, only a handful of funds beat the indices. And there’s no tried-and-true way of picking these funds in advance.

The reason “skilled” portfolio managers can’t beat the market, Hebner says, is that the market is primarily made up of other “skilled” portfolio managers, and they trade against each other all day long. When your competition is as well-educated, well-funded, and skilled as you are, you’re going to lose as much as you win. And when you subtract the fees that you charge your investors from your investment performance, the result is performance that lags the index.

Hebner’s advice is to follow in John Bogle’s footsteps and buy a diversified portfolio of index funds. Unlike actively managed mutual funds, index funds guarantee you close to a market return. And if you rebalance your portfolio whenever your asset allocation gets out of whack, you can actually do better than the market over the long haul.

This post originally appeared at Yahoo! Finance.