Approximately 75% of fund managers do not beat the S&P 500 year in and year out. How can a basket of 500 hundred stocks beat the majority of actively managed mutual funds? The people who manage these funds are, for the most part, brilliant people. They are highly educated and have access to the most advanced information and decision support systems in the world. So why is it that they do not outperform the S&P 500?

A Quick Test:

Here's a very crude test of management performance: Let's compare the domestic-equity mutual fund performance supplied by Morningstar against the S&P 500 index for one, three, five and ten-year periods, looking back from April 30, 1995. The S&P 500 index is a fair comparison for large, domestic companies.

Our results:

--Of the 1,097 funds Morningstar covered for the one-year period, 110 beat the S&P 500, while 987 fell short. Results ranged from 46.84% to -32.26%, while the S&P 500 attained a 17.44% return.

--During the three-year period, the S&P 500 returned 10.54%, while results in the funds varied from 29.28% to -15.02% compounded annually. Of the total 609 funds, only 266 beat the S&P 500.

--Shifting to the five-year period, of 470 funds, 204 beat the S&P 500. Results ranged from 27.35% to -8.51%, while the index racked up 12.62%.

--At ten years, only 56 of 262 funds managed to beat the index, and results varied from 24.77% to -4.06% compounded annually against 14.78% for the S&P 500.

The fact that most funds do not beat the overall stock market should not be surprising. Since the majority of money invested in the stock market comes from mutual funds, it would be mathematically impossible for the majority all of these funds to out perform the market.

The implied promise held out to investors in actively managed mutual funds is that in exchange for higher fees (relative to index funds), the actively managed fund will deliver superior market performance. There are a host of barriers to fulfilling this implied promise.

Some of the problems are:

--The larger a mutual fund gets, the more difficult it becomes to deliver exceptional performance.

--Although fund size runs counter to performance, fund managers have a strong motivation to let the fund grow as big as possible because the bigger the fund gets, the more money the fund managers make.

--Most skillful mutual fund managers are hired away by hedge funds, where their financial rewards are greater and there are few restrictions on investment techniques.

--By law mutual funds are supposed to be conservative, which in theory limits their potential losses. This conservative stance generally limits their ability to use arbitrage, options, or shorting stocks.

Can You Do Better?

Because of the general inflexibility and restrictions of most mutual funds, your investment capital is not properly hedged against market fluctuations. In most cases, if you compared the beta of the equity exposure held in actively managed mutual funds to an equal equity exposure to the S&P 500 index, your reward/risk ratio would be less rewarding than purchasing an identical equity exposure to the S&P 500 index. So, the answer is, you can do better and beat the S & P 500 by using an effective stock market timing system.