Harsh truth about managed funds

Here's something many fund managers would prefer wasn't discussed: most of them are probably failing to create

long-term value.

Despite the billions the industry soaks up every year, statistics show that after fees, most funds underperform over the long term.

Take the latest figures from Mercer comparing big funds' returns with the ASX 200. Before fees, the typical fund has posted returns of 7.4 per cent in the three years to March, which is a tad better than the index returns of 7.2 per cent.

But this advantage is wiped out once annual fees - which are typically between 1 per cent and 2.5 per cent of assets under management - are taken into account. It's a similar story for returns over the last year, while over five years pre-fee returns from the typical fund are ahead of the index by a fairly skinny 1.2 per cent a year.

The graph reveals similar results in the US. After fees, an average of 60 per cent of US managed funds have performed worse then the benchmark in a calendar year over the last decade.

So why do the professionals have such a patchy track record?

In truth, the pros face many of the same challenges small investors grapple with. For one, the law of averages says funds are unlikely to consistently outperform. No matter how good your information or analysis, it's very hard to consistently beat the market when everyone else is trying just as hard to do the same thing.

Top performers in one year are eventually replaced by someone else.

This is why funds always warn that past performance is not a guide of future returns - though many of us instinctively assume last year's winners will perform well again this year.

A second trap is excessive trading in stocks. The Economist recently published research showing that average turnover in American mutual funds had shot up from 15 per cent in the 1950s to near 100 per cent today.

Every time a fund manager makes a trade, they incur costs in brokerage. Over time, these small costs add up.

It's easy to make the same mistake as a small investor, trading too frequently on the latest bit of information.

A final trap facing fund managers is more psychological - and it's something DIY investors can try to avoid. Many fund managers have a tendency to "follow the pack" in their stock selections, even though this may not lead to outperformance.

Why would they do this? A lot of the time, managers are judged and rewarded with bonuses on the basis of how they perform against their peers or the index over a set period of time.

This gives them an incentive not to stick their necks out and make bets that are very different to their competitors.

If the market is piling into high-yielding stocks, many feel compelled to follow the herd and buy high-yielding stocks. It's less risky than being a contrarian and seeking out some other opportunity.

Top investors such as Warren Buffet are famous for doing things differently to their peers, of course.

Some of Buffet's typically bold moves have included avoiding technology stocks during the early 2000s tech bubble, and snapping up the right to buy a big a stake in Goldman Sachs at the height of the 2008 global financial crisis.

But making decisions such as those is not for the faint-hearted - whether you're an amateur or a pro.