For more than thirty years, mutual funds as a group have generated essentially zero or even negative alpha—the returns to an investor over and above what could be earned from investing in a simple benchmark index. Studies evaluating data from mutual funds have found that very few are able to beat a risk-adjusted benchmark and, as a result, anywhere from 92% to 99% of funds generated negative alpha for investors depending on the time period examined.[1]
The negative alpha effect is even stronger for broker-sold funds than direct-sold funds, perhaps because of differences in incentives.[2] To be clear, this does not mean mutual funds are producing negative returns—they aren’t—but it does mean that, in principle, the typical mutual fund investor would earn higher returns, even on a risk-adjusted basis, with a passive or semi-passive/factor-based investment portfolio.
All of this is not an opinion—it’s a simple data-driven fact based on more than 90% of funds generating negative alpha. Yet, the natural conclusion from this set of facts—that investors would be better off investing on their own in a passive portfolio—is controversial, debatable and not well supported by empirical research evidence.
Why?
The answer lies in the value that financial advisors offer. Quite simply, while mutual funds have a very difficult time picking winning stocks, individual investors are of course no better at it, and unshackled from the stability in trading that comes with having a financial advisor, individual investors trade far too much and at the wrong times.[3] Typically, when left to their own devices, individual investors panic when the market goes down and they sell their investments. Then, driven by fear, they stay out of the market until it has rebounded to new highs, before buying in based on over-exuberance. Then in typical fashion, the market experiences a correction and the process repeats. In other words, investors in general cannot handle the volatility of the markets and tend to make terrible investment allocation decisions as a result.
The key point then is that the value financial advisors play is not in picking stocks or mutual funds—it is in helping investors to set sensible asset allocations and then stick to those asset allocations over time throughout the market roller coaster ride, only making adjustments as the investor’s life circumstances evolve. It turns out that it is much more important for financial advisors to be good asset allocators than stock pickers at the end of the day, and financial advisors who remember this will thrive over time.
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[1] See among others: Barras, L., Scaillet, O., & Wermers, R. (2010). False discoveries in mutual fund performance: Measuring luck in estimated alphas. The journal of finance, 65(1), 179-216. And Huang, R., Pilbeam, K., & Pouliot, W. (2021). Do actively managed US mutual funds produce positive alpha? Journal of Economic Behavior & Organization, 182, 472-492.
[2] See Huang, R., Pilbeam, K., & Pouliot, W. (2021). Do actively managed US mutual funds produce positive alpha? Journal of Economic Behavior & Organization, 182, 472-492.
[3] See for instance: Bhattacharya, U., Loos, B., Meyer, S., & Hackethal, A. (2017). Abusing etfs. Review of Finance, 21(3), 1217-1250.
