By Dr. Tim Price, CPA, CMA, CAM, Faculty Member, School of Business, and Dr. Suzanne Minarcine, Faculty Director, School of Business

Prior to the 1980s, the only individuals who owned mutual funds were those who had money and those who had educated themselves on investing. Most Americans had a pension and Social Security, so investing for their retirement was not a huge concern.

Retirement funding changed in the 1980s as globalization ramped up and U.S. companies found themselves in a far more competitive world. As a result, companies began to take a hard look at their expenses.

One of the most significant expenses was the funding of employee pension plans. That high cost led many companies to move away from the traditional pension plan, where the company fully funded employee pensions, to the 401(k)-type savings plan where employees contribute and the company matches a percentage.

Companies Popularized 401(k) Plans Because They Reduced Costs

401(k) plans have costs for both the employer and the employee. But with 401(k) savings plans, a company’s only costs were the relatively insignificant administrative fees and any employer matches to employee contributions. Those costs vary according to the structure of a particular plan.

With the proliferation of 401(k) plans, many companies contracted with mutual fund companies to give their employees the opportunity to invest in these funds. As a result, the number of mutual funds and the amount invested in them grew.

In 1980, only 6% of U.S. families owned mutual funds, and this number grew to 44% in 1998. The amount of money invested in mutual funds in the United States increased from $1.6 trillion USD in 1992 to $5.5 trillion in 1998, an increase of 17.7%.

On the surface, this would seem to be a positive trend. However, two issues need to be addressed:

• Most individuals have no clue how to invest their money.
• The average investor in mutual funds has no idea of the costs imposed by the mutual fund companies.

Mutual fund companies charge consumers both fees and expenses. These costs are difficult for uninformed consumers to identify.

Mutual Funds Require Thorough Research: Past Performance Does Not Guarantee Success

Given the browbeating that we often give car salespersons, appliance salespersons and other retailers regarding costs and add-on fees, it is difficult to understand why we do not also conduct a thorough investigation before we invest in retirement funds. We tend to treat mutual funds as if they are sacrosanct and will take our money and do everything they can to use it efficiently.

The truth is that mutual fund companies tend to be inefficient and they pass those inefficiencies on to their investors in the form of additional costs. Consumers generally do not realize that a fund’s past performance is not a predictor of its future performance; it is simply an assessment of the fund’s volatility or its potential to fluctuate based on the risks associated with the stocks.

A mutual fund’s benchmark is the performance measurement standard and will depend on the type of fund and the stocks included in it. Common benchmarks are the S&P 500, the Dow Jones Industrial Average and even other mutual funds in the same category.

The average actively managed mutual fund does not beat its benchmark. In fact, numerous studies indicate the following:

• Over five years, only 33% of actively managed mutual funds beat their benchmark.
• Over 10 years, only 25% of actively managed mutual funds beat their benchmark.
• Over 20 years, only 20% of actively managed mutual funds beat their benchmark.
• Over 30 years, only 14% of actively managed mutual funds beat their benchmark.
• Over 40 years, only 12% of actively managed mutual funds beat their benchmark.

The average investor in mutual funds is not aware of these inefficiencies and failures to reach benchmarks. Certainly, mutual fund companies do not plan to reveal this information to their customers anytime soon.

Passively Managed Mutual Funds Now More Common in Companies

Currently, there is a trend that is away from actively managed funds to passively managed funds. Passively managed funds are index funds, which are constructed based on predefined rules and bought by a company as a group of stocks to hold forever, unless there is a change in the fund group. Costs are low because stocks are not actively traded within the fund and there is minimal involvement oversight by fund managers.

The costs associated with passively managed mutual funds are significantly lower than for actively managed funds. For example, the estimated average cost for actively managed mutual funds is approximately 4%. Conversely, passively managed funds have an average cost of 1%.

The difference in cost is due to the following factors:

• Stocks are not actively bought and sold; therefore, there are no transaction commissions for the passive fund manager. Stocks are generally chosen by computer.
• There are significantly lower brokerage commissions, since there is very little trading activity.
• The cost imposed by the difference between the bid and ask price is significantly reduced. The bid price is what someone is willing to pay for the stock, and the ask price is the price of a stock that someone is willing to sell.
• The cost imposed when prices increase as large purchases are made by actively managed funds is lower.
• The loss of income from cash held by actively managed funds is significantly reduced, because cash is generally reinvested.
• Federal taxes are lower.
• Advisory fees are lower, because the passively managed fund does not require a full-time fund manager.

Americans Should Improve Their Investing Knowledge to Protect Their Retirement Funds

Americans need to do a better job of educating themselves about investments. In addition, the companies that offer 401(k)-type plans should be more transparent and provide better assistance in explaining their fees and costs.

As mutual funds increasingly replace pensions as a major source of retirement funds, investors need the tools to make prudent decisions for their future.

About the Authors

Dr. Tim Price is a faculty member in the School of Business. His teaching interests include accounting, economics, finance and statistics. Tim holds a Ph.D. in Business Administration and an M.B.A. in Business Administration from the University of South Florida, as well as a B.S. in Accounting from Pennsylvania State University.

Dr. Suzanne Minarcine is the faculty director for the School of Business. She currently teaches strategic management, leadership, and entrepreneurship courses.