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                                                                                                                                                  Finance




              Should Individual Investors
              Buy Mutual Funds?
              Mutual funds pool money from many investors and purchase stocks, bonds, and
              other securities. Mutual funds allow investors with moderate wealth levels to hold
              a diversified and professionally managed portfolio at relatively low costs. This article
              discusses the recent growth in mutual fund assets and the aggregate performance
              of mutual funds.



              T    he mutual fund sector has grown
                   dramatically over the last decade. The
              worldwide mutual fund assets increased
                                                                Exhibit 1: Distribution of worldwide mutual fund assets in 2005


              from around USD 5 trillion in 1995 to over
              USD 17 trillion in 2005 according to the
              Investment Company Institute (ICI). There                       Other World
                                                                                                                    U.K.       Ireland
              are currently more than 50,000 different
              mutual funds available in different coun-                                                                             Italy
              tries.                                                                                      France                      Spain
                                                                                                 Europe                               Germany
                   “It is unfortunate that                                                                                            Sweden
                                                                     U.S.
               Switzerland as an important                                                                                            Switzerland
                                                                                                          Luxembourg
                 financial center does not                                                                                         Other Europe

              belong among the top players
                in the mutual fund arena.”
                                                                                                                   Source: Investment Company Institute
              This substantial number of funds is
              caused by a large demand for variety,
              high competition, and geographic mar-
              ket segmentation. Mutual funds investors        funds to take full advantage of economies     Performance of mutual funds
              demand variety due to differences in risk-      of scale.
              aversion, time horizons, liquidity needs,          The assets under management at             Despite the professional management
              and tax considerations. The significant         mutual funds differ dramatically across       of mutual funds, the performance of the
              competition in the mutual fund sector           countries. Exhibit 1 depicts the relative     average mutual fund appears to be rela-
              also contributes to the large number of         size of home-domiciled funds in 2005.         tively disappointing. Exhibit 2 summa-
              funds since each fund family offers its         The U.S. accounts for about half of the       rizes the average aggregate returns of
              investor a set of basic mutual funds to         worldwide size of mutual funds. On the        all domestic equity funds offered in the
              enable a “one-stop-shopping.” This ne-          other hand, European funds contribute         U.S. since 1980. The reported returns are
              cessarily results in a duplication of similar   about one-third to the total worldwide        weighted by the size of the mutual funds
              funds. For example, in the U.S. there are       value of mutual funds. Because of favor-      to ensure that the numbers represent the
              currently more than 50 index funds that         able tax and regulatory environments,         aggregate performance of funds. I focus
              all hold the identical 500 stocks in the        Luxembourg and Ireland control a large        my analysis on U.S. mutual funds due to
              Standard & Poor’s 500 index. Finally, due       share of the European mutual fund mar-        data availability. However, I suspect that
              to regulatory restrictions mutual funds         ket. On the other hand, funds domiciled       the performance of Swiss mutual funds
              can often not be offered in multiple coun-      in Switzerland account for only about 2       is not dramatically different from their
              tries. Therefore, mutual fund companies         percent of the assets of European mutual      U.S. counterparts.
              are forced to set up separate funds in dif-     funds. It is unfortunate that Switzerland         Mutual fund investors in the U.S. real-
              ferent countries. Such a segmented mar-         as an important financial center does not     ized an average return of about 12% be-
              ket structure increases the costs of mutu-      belong among the top players in the mu-       tween 1980 and 2005. More recently, the
              al fund investors because it does not allow     tual fund arena.                              average equity fund returns have been


                                                                                                                         business guide to switzerland ■ 45
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                                                                                                                                                              Finance



              lower due to less favorable market con-           vestors at a quarterly frequency. We use             The performance of mutual funds is com-
              ditions. Since 2000, mutual fund investors        these disclosed stock positions to com-              parable with the performance of the aggre-
              did not gain from their equity investments.       pute returns of a hypothetical portfolio             gate stock market. Mutual fund investors
                  Investors and the media often compare         which includes the previously disclosed              cannot expect to obtain extra-ordinary re-
              the performance of mutual funds to the            equity positions. The return of this hy-             turns by investing in diversified mutual
              performance of the aggregate U.S. stock           pothetical portfolio is better comparable            funds. However, investors with moderate
              market. Mutual funds, on average, do not          with the average market return since it              wealth levels tend to be better off with
              appear to outperform the aggregate stock          does not include trading costs and also ig-          mutual funds than by managing their
              market. Between 1980 and 2005, mutual             nores cash positions. We observe that the            equity portfolios on their own.          ■

              funds underperformed the U.S. stock mar-          equity holdings of mutual funds over the                                                   Clemens Sialm

              ket (which is approximated using the value-       whole sample period between 1980 and
              weighted returns of all publicly traded           2005 exceeded the performance of the
              stocks in the U.S.) by 0.7 %. A similar           market index by about 1 % per year, as
              under-performance occurs over the two             shown in Exhibit 2. These results show
              shorter time periods. Thus, investors in          that fund managers have investment abili-
              U.S. equity funds tend to perform worse           ty but that management and trading costs
              than the aggregate stock market.                  and cash holdings reduce the performance
                  By comparing mutual fund returns              below the index.
              with aggregate market returns, we com-
              pare apples with oranges for several rea-
              sons. First, whereas the aggregate market                “Funds with stellar past
              index returns exclude costs, the mutual
                                                                      performance often do not
              fund returns reported in Exhibit 2 include                                                                                       Clemens Sialm
              these costs. Fund families charge fund in-              continue to perform well
              vestors annual expenses. For example, the                    in the future.”                              About the author
              annual fund expenses averaged about                                                                       Clemens Sialm grew up in Romansh-speak-
              0.87 % per year between 1980 and 2005.                                                                    ing Disentis (Switzerland) and went to
              In addition, the trading of the securities        The previous results only report aggre-                 college at the University of St. Gallen. He
                                                                                                                        did his Ph.D. in Economics at Stanford
              causes transactions costs which reduce            gate returns. There is a significant per-
                                                                                                                        University and became an Assistant Pro-
              the overall performance of the funds. Sec-        formance difference among funds. For                    fessor of Finance at the Ross School of
              ond, equity funds tend to hold about 5 %          example, in 2005, 5 % of equity funds had               Business at University of Michigan in 2001.
              of their assets in cash or short-term fixed       returns exceeding 75 % and 5 % of funds                 Sialm’s research interests are in the areas
                                                                                                                        of investments and taxation. He analyzes
              income securities to satisfy the liquidity        have returns below -50 %. Despite this
                                                                                                                        the investment strategies and the behavior
              demands of their investors. These invest-         large variation, it is extremely difficult to           of mutual funds and hedge funds. Further-
              ments tend to reduce the average per-             predict funds that perform well in the                  more, he investigates the impact of the
              formance of mutual funds relative to stock        future. In particular, funds with stellar               tax system on asset prices and optimal
                                                                                                                        portfolio decisions. His research has been
              market indices that only include the per-         past performance often do not continue
                                                                                                                        presented at the main finance and eco-
              formance of equity securities.                    to perform well in the future. Individual               nomics conferences and has been pub-
                  To be able to compare more fairly the         investors tend to fare well by holding                  lished in the top finance journals. The re-
              performance of mutual funds with the              funds with low fees and stable invest-                  search has also been featured in the Wall
                                                                                                                        Street Journal, the New York Times, Busi-
              market index, Marcin Kacperczyk from the          ment strategies and should not mindless-
                                                                                                                        ness Week, and the Financial Times,
              University of British Columbia, Lu Zheng          ly chase funds with stellar past perform-               among others.
              from the University of California at Irvine       ance.
              and I analyze the performance based on
              the equity holdings of mutual funds.1 Mu-                                                                 About the school
                                                                1
                                                                    The study on “Unobserved Actions
              tual funds in the U.S. are currently requir-                                                              Stephen M. Ross School of Business is
                                                                    of Mutual Funds” is available at
                                                                                                                        the business school of the University of
              ed to disclose their equity holdings to in-           http://webuser.bus.umich.edu/sialm/
                                                                                                                        Michigan in Ann Arbor, USA. It offers un-
                                                                                                                        dergraduate, graduate, and doctoral de-
                                                                                                                        grees, as well as an executive education
                                                                                                                        program. The Ross School has highly
                                                                                                                        ranked MBA and Executive Education pro-
                 Exhibit 2: Average performance of U.S. domestic equity mutual funds
                                                                                                                        grams. Many renowned publications have
                 Time range        Aggregate           Aggregate                 Aggregate           Aggregate          ranked both the school’s undergraduate
                                      mutual                 market     equity mutual fund                expense       and professional programs highly, often
                                  fund return                return         holdings return                  ratio      as one of the top ten in the U.S. In the
                 1980–2005            12.0 %               12.7 %                   13.7 %                0.87 %        year 2006 the Wall Street Journal ranked
                 1990–2005             9.4 %               10.2 %                   11.1 %                0.94 %        the program No. 1 overall; in 2006 Busi-
                                                                                                                        ness Week ranked the program No. 5
                 2000–2005             -0.1 %                0.3 %                   0.8 %                0.95 %
                                                                                                                        overall.
                                           Sources: Own computations based on CRSP and Thompson Financial



                                                                                                                                   business guide to switzerland ■ 47