Many people are invested in mutual funds. Most people have no clue how to tell if their mutual funds are better or worse than average. Many people allow their financial advisor, planner, accountant, or fee-based advisor (broker) to put them into mutual funds but must take their advisors word for the "best-in-breed" claim. Unfortunately the reality is that actively managed mutual funds do not out perform their unmanaged benchmarks on a risk-adjusted basis after taking fees into account. Furthermore, the mutual funds that do outperform their benchmarks on a risk-adjusted basis over trailing five and ten year periods are unlikely to outperform going forward. In other words, the top ten performing mutual funds in a market segment - say large cap - over the trailing ten year period are unlikely to be the same funds that out perform over the following ten year period. Bottom Line? There is no way to know in advance which funds will outperform their benchmarks on a risk-adjusted basis, net of fees, over five and ten year periods.
Now stop and think through what I just wrote. Most financial advisors tout their mutual fund picking ability as a primary reason to hire them (never mind the fact that their advice is often skewed by which funds pay the best commission!). Yet the brainiacs ensconced in the ivory towers of Wharton, the University of Chicago, and Harvard will tell you in excruciating detail why it is impossible to know a priori which mutual funds will out perform their benchmarks. John Bogle of Vanguard has it right! Index funds will beat the majority of actively managed mutual funds over long periods of time and, therefore, are above average!
Now stop and think about THAT for a moment. You can actually outperform the majority of mutual funds over the long run simply by indexing. Furthermore, since an index fund merely matches its benchmark's risk (average risk) yet outperforms the majority of peer group funds, you are able to know in advance that you are investing in a fund with a favorable risk/reward relationship (average risk and above average reward). And you didn't even need a Morningstar report to figure it out!
But since many of you are determined to speculate on mutual funds much in the same way that many of you speculate on individual stocks, here's the appropriate way to measure your actively managed fund's performance. You must compare your fund to the asset subclass in which it invests. A large cap growth fund should be bench marked against the Russell 1000 growth index and a large cap value fund should be bench marked against the Russell 1000 value index. In both cases, you should adjust for risk. Unfortunately, even then it isn't quite so simple since most fund managers cheat. Large cap fund managers will add small and mid cap stocks, or foreign stocks to their portfolio in an effort to beat their benchmark by going outside the appropriate universe of stocks. Of course they will sell those stocks before the required reporting period so that no one is the wiser - the practice of cleaning up the portfolio prior to reporting holdings is known as window dressing and is a common Wall Street practice.
To recap: Investors who use mutual funds should index. The academic case is overwhelming. Index funds outperform the majority of their actively managed peer group with only average risk. You don't need a fee-based financial advisor (aka broker) to pick actively managed mutual funds for you, since he's whistling in the dark anyway, while collecting commissions on those A, B, and C shares. What you need is someone to help you arrive at an appropriate strategic asset allocation and then implement that allocation with index funds. Better still, seek out a financial advisor that employs Chartered Financial Analysts capable of building low-cost stock portfolios chock full of businesses purchased at less than their fair market value, because the same academic research that categorically shows it is better to index than attempt to pick mutual fund outperformers, also shows that value investing outperforms the market over the long run!
