Change the Holy Grail of the Mutual Fund Industry

In previous blog posts, I've discussed the dismal performance of actively managed mutual funds. I also noted this underperformance has not gone unnoticed by investors. Actively managed funds have experienced massive outflows through September, while index funds have seen net inflows for the past eight months.

The slim chance of "winning." But this isn't the time for proponents of "evidence-based investing," as I call it, also known as index-based investing or passive management, to rest on their laurels. Americans pay approximately $600 billion in fees each year to active fund managers who claim the ability to "beat the markets," according to State Street calculations derived from Boston Consulting Group's Global Asset Management 2014 report. To put that number into perspective, it's a little less than the gross domestic product of Switzerland.

Noah Smith wrote in a Nov. 20 BloombergView article, called, "Why Some Money Managers Succeed by Losing," that the majority of index funds outperform actively managed mutual funds every year, and especially over the long term. The "best of the best" fund managers are supposedly those who run hedge funds. In the aggregate, these funds have underperformed the Standard & Poor's 500 index by 97 percentage points since the end of 2008.

The future is not bright for active managers. Competition is greater. Information is being disseminated faster. As Charles Ellis, author of the book, "Winning the Loser's Game," noted in Financial Analysts Journal, the investment industry is now populated by more talented professionals who have "more advanced training than their predecessors, better analytical tools and faster access to more information."

As a consequence, the probability that active managers will beat their benchmark index, especially after costs and fees, has significantly diminished. Ellis says that although active managers do not face an impossible task, the odds of beating the market are so low, it makes little sense for investors to even play the game.

Counter your broker's pitch. Investors who take the time to study the data in an unemotional and objective manner will conclude buying actively managed funds is a zero-sum game. These investors will limit their investments to a globally diversified portfolio of low management fee index funds, in a suitable asset allocation. Unfortunately, most investors are lured by slick advertising and glib brokers, who tell them they have the expertise to select those few fund managers who can outperform, and thus "beat the market."

Few investors are prepared to counter this marketing blitz by referencing a seminal study by Nobel laureate Eugene Fama and Kenneth French, entitled, "Luck Versus Skill in the Cross-Section of Mutual Fund Returns." This study found that there was evidence of statistically significant skill in only 2 percent of fund managers. There is no way to identify these skilled fund managers prospectively. Even if you could, after costs and expenses, investors yielded little, if any, returns over the returns of the benchmark index.

Pay for performance. Active fund managers currently have a sweet deal. They are compensated based on a percentage of assets under management. While their compensation increases if the fund they manage goes up in value, they incur no penalty if they fail to meet, or even underperform, their benchmark.

A recent study by the Cass Business School in the United Kingdom, took a refreshing look at this fee structure, which is also in place in many U.K. mutual funds. The study is appropriately titled, "Heads We Win, Tails You Lose." The authors analyzed three alternative fee arrangements:

-- Fixed fee: This is the arrangement in place at virtually every mutual fund in the U.S. and the U.K. The fund is compensated based solely on assets under management.

-- Asymmetric fee: The fund manager receives a base fee predicated on assets under management, plus a performance fee based on upside performance. This fee is commonly utilized by hedge funds.

-- Symmetric fee: In this arrangement, investors and managers would share in the upside and downside, based on performance. This fee is rarely used by mutual funds.

The authors of the study concluded that the fixed-fee arrangement is "generally the best structure for the manager and the worst for the investor!" The results of this study indicated the symmetric fee structure, "is, on the whole, in the best interest of investors. How long can an industry ignore the best interests of its customers?"

Dr. Nick Motson, one of the authors of the study, posed this question: "Since investors would prefer symmetric, performance-based charges, why don't more fund managers offer such fees?" The answer, Dr. Motson, is obvious. Under the present system, it's "heads they win, tails investors lose." Don't expect any changes to this cozy fee system in the near future.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."