YOUR FUND IS NOT UP TO PAR

By Daniel Kadlec

You wouldn't bet your retirement savings on a 1-in-5 chance--or would you? Check your latest mutual-fund statement. You may be gambling more than you know.

One of the fund industry's not-so-funny little quirks is that most stock-fund managers can't beat important benchmarks like the Standard & Poor's 500, even though they try with all their might. That index represents the average stock. In theory, half of all funds should beat it while half fall short. In reality, in the past 10 years only 20% of diversified, actively managed U.S. stock funds have done better. Laggards include big names such as Income Fund of America, with assets of $16 billion, and Fidelity Puritan, with assets of $19 billion.

In plain English, fund lovers, that means the vast majority of you, through fees levied against your funds, have been paying professionals for the privilege of earning subpar returns. That's only supposed to happen in baseball. Last year just 25% of stock funds matched the S&P 500. In 1995 the number was a pitiful 16%, and in 1994 it was 23%, according to Lipper Analytical Services. If fund managers simply threw darts at a stock table, you'd expect more to match the benchmark.

This is no small matter. Over time, lagging stock funds take a huge bite out of what you might have earned. During the past 10 years, the average stock fund rose 260%, vs. 314% for the S&P 500. If you had invested $10,000 in the average fund, it would have become $36,000; in the S&P 500, $41,400--15% more.

What are you doing about this problem? Throwing more money at it. The public pumped an estimated $223 billion into stock funds last year, nearly all of it into actively managed funds. It has been amply rewarded. "Measured against where all the money was 10 years ago--in banks--they've done great," says Robert Schmidt, president of Individual Investor Group, a financial-magazine publisher. He's right. Even bottom-tier funds in the '80s and '90s have been good enough to embarrass bank CDs, the likely repository for savings that aren't in stocks. Still, people left CDs for a reason. Having correctly made that tough decision years ago, they should not be grateful now for lackluster results. Even though their money on the whole has more than tripled in stock funds in 10 years, it could have quadrupled if only more managers were simply average.

There have been plenty of good funds, of course. In the same 10-year period, Twentieth Century Giftrust rose a whopping 617%--turning $10,000 into $71,700. FPA Capital jumped 595%; PBHG Growth Fund popped 589%. And the really good news is that the 20 largest stock funds, which together account for nearly a third of all assets in domestic stock funds, have come much closer to matching the S&P 500 than most. If you own any of the winners, count your blessings. Just don't count on continued outperformance.

The sad fact is that fund investors have the deck stacked against them when it comes to beating the averages. Here's why:

Fees. The fund industry never met a fee it didn't like. There are management fees, 12b-1 fees, custodial fees, transfer fees, accounting fees, directors' fees and professional-services fees, to name the most common. This litany of levies, assessed each year, typically totals 1.4% of assets in a fund and reduces the return by roughly that amount. And that doesn't include the impact of one-time sales charges of up to 6%. Such "loads" aren't reflected in official performance data but are a cost that cuts into your results.

Turnover. In the typical stock fund, 4 out of 5 stocks held at the start of the year are gone by the end of the year. The trading costs subtract an additional .6% from a fund's investment gains.

Cash. The typical fund keeps 7% to 10% of its assets in cash, a stash to pay off investors redeeming shares. That part of the portfolio is a drag on performance when the stock market is hot.

"The costs eat you up," says John Bogle, a low-fee fanatic and chairman of mutual-fund company Vanguard Group, which champions "index funds" as the surest road to long-term investment success. Over long periods, Bogle says, it's inevitable that managed funds will trail the benchmarks by roughly 2 percentage points a year, reflecting their costs. But index funds such as Vanguard's Index 500, which mimics the S&P 500 by owning essentially the same stocks, have low fee structures and allow individuals to easily approximate the market's average return year after year. Last year the Index 500 rose 22.86%; the S&P 500, 22.95%. Over 10 years, the Index 500 has risen an average annual 15.04%, just behind the S&P 500 index gain of 15.29%. Meanwhile, the average general stock fund has been lagging: 19.4% last year; 12.5%, on average, each of the past 10 years. Historically speaking, those returns are phenomenal. But next to the average returns easily available through index funds, they pale.

Last year's results suggest the gap is widening, indicating that something more than fees is the problem. Ironically, no one seems to pin it on the influx of thirtysomething fund managers hired as part of the industry's explosive growth. "In a bull market like this, youth is an asset," argues Michael Lipper, president of Lipper Analytical. The young have no recollection of, and thus no fear of, a declining market. That translates into being fully invested and having got the most out of stocks during this exceptional rally.

So what does account for the widening gap? When stocks are flying as they are now, even discerning managers blindly plow money into the big stocks that make up major indexes. They want to hold little cash so it doesn't drag down performance. But the cash comes into their funds so fast that they can't find enough lesser-known stocks to spend it on. So they park ever more money in big stocks, which are easy to buy and sell, while searching for true bargains.

That behavior tends to drive up the indexes and leaves fund managers reluctant to sell their big stocks, which are rising. The end result is that large stocks take off, and the lesser-known stocks in most funds--the ones being counted on to provide the most kick and produce superior results-- instead hold the funds down.

"The last few years are clearly unique," says investing legend Peter Lynch, vice chairman of fund company Fidelity Management Research. "Huge companies have been beloved." In that environment, fund managers with even small doses of non-index stocks don't have much chance of beating the indexes. But, Lynch notes, active fund managers have sparkled at times, as in 1991-93, when the postrecession economy was lifting small stocks fastest. In 1991 the average fund rose 37%, vs. 30% for the S&P 500, and 60% of funds beat the benchmark.

Lynch believes index funds make sense for investors who would otherwise switch their money furiously, chasing the latest fund fad only to get there late each time. Indeed, Fidelity is doubling its index-fund offerings from three to six this year. But, Lynch says, it's wrong to assume large stocks will be in favor forever. "That's not the history of the stock market," he says. "And it won't be true the next 30 years either. Giant companies run out of gas."

That's when managers looking outside the index stocks could regain the advantage. Now may be the wrong time to lurch into index funds. "They've outperformed a long time," Lipper says. "And the history of the market is regression to the mean"--meaning some other segment may be ready to do better as index stocks come back to earth.

As always, what will happen next is impossible to say. What's clear is that the indexes have been trouncing the typical stock fund for a long time. Even if this era of big-stock bias fades soon, the fee fest that comes with actively managed funds is a lot to overcome. Your odds are good in a fund with a steady manager and a superior record. But if you find yourself paying fund managers who can't find the ocean from the beach, index funds are a solid alternative.