Why pension funds beat mutual funds

Nibbling away at your return Because of high operating costs, mutual funds lag pension funds. If stocks return 6% a year, here's what the gap does to you, before counting official expenses. Invest In 10 years you'll have: $10,000 at 6% $17,900 $10,000 at 4.6% $15,600

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(Money Magazine) -- Are you happy with how well your mutual funds are doing?

Didn't think so. Over the long run, two-thirds of stock funds deliver less than the market as a whole - a performance most of us can stomach, barely, when stocks are doing well. But in a market as stingy as the one we've endured since 2000, below-average results really hurt.

So are mutual funds doomed to underperform? Not necessarily, and new research shows how you can find better funds more reliably.

Experts have long struggled to explain why pension funds - the big pools of money run for traditional corporate and government retirement plans - tend to outperform mutual funds even when they're run by the same people investing in the same stocks.

The simple explanation: Mutual funds charge more because they cost more to run. A pension fund doesn't have to advertise how great it is, maintain a 24-hour toll-free phone bank or mail out tens of thousands of prospectuses.

Mutual funds do, and that gives them higher expenses than pension funds - depending on how you count, between 0.03 and 0.3 percentage points a year, or up to an extra $3 on every $1,000 you invest.

But there's a lot more at stake here than three bucks. The difference between pension funds and mutual funds goes way beyond what gets recorded as expenses.

A new study led by Rik Frehen, a Dutch finance scholar, looks at the stock-investing records of pension and mutual funds in the U.S. - and the findings are fascinating and alarming.

Comparing the returns of 700 pension funds against those of 4,000 mutual funds between 1992 and 2004, Frehen found that both categories had underperformed the broader market but that pension funds had killed mutual funds.

The former had trailed the market by 0.1% a year, beating mutual funds by at least 1.4 percentage points a year, on average, after adjusting for expenses, risk, the size of the funds and their style of investing.

Now we're no longer talking about three dollars. Over the period that Frehen and his colleagues studied, $10,000 in a mutual fund would have returned just under 9% a year, giving you $30,000.

But the same amount invested in a pension fund would have grown to $36,000, or 20% more. If the stock market returns an average of 6% annually after inflation, you'll give up more than a quarter of your gain by being in a mutual fund - and that's before you pay your annual expenses.

What accounts for this huge gap? Much of it lies in how mutual fund managers are compensated and judged. Managers get paid on the size of the portfolios they run and on the basis of quarterly and annual performance - pressure that pension fund managers don't generally face.

That incentive scheme can lead to behavior that hurts you. To goose short-term results and make a mutual fund appear to own the "right" companies when it reports holdings to investors, managers trade stocks too frequently. Trading doesn't cost the manager anything, and it's not reported as an expense to the fund, but the resulting brokerage costs erode your return by up to 1% a year.

Also, some funds allow big investors to put in and yank out tens of millions of dollars at a time, maximizing the funds' assets but also raising trading and tax bills. Finally, funds pay brokers for "shelf space," or preference in sales campaigns. One way or another, that also comes out of your pocket.

Your behavior can hurt performance too. Research shows that when tons of money pour into a hot fund with a great recent track record, the stocks it then buys go on to underperform the market; meanwhile, when a fund goes cold and money flows out, the stocks it sells to cash out investors subsequently outperform.

In short, investors often force their mutual fund managers to buy expensive stocks and sell cheap ones. The only real solution is for managers to close their funds to keep "hot money" out - something most are reluctant to do. Pension funds, on the other hand, get a steady and stable inflow of cash, so they don't have these kinds of problems.

But all is not lost. Some funds do outperform over time. To increase your chances of finding them, look for ones offered by the small and mid-size fund companies I call owner-operators, where the portfolio managers invest heavily both in their own funds and in the company that runs them.

Trading too much, churning up tax bills or shooting for short-term gains will hurt these managers almost as much as it will hurt you. They'll close hot funds to new investors; they'll try to keep a lid on fees. Their interests are aligned with yours, helping them stay focused on the long term.

Among such firms are Ariel, Bridgeway, Davis, FPA, Longleaf, Numeric, Oakmark, Third Avenue and Tweedy Browne.

Finally, you can buy a whole-market index fund from a low-cost firm like Fidelity, T. Rowe Price or Vanguard - which eliminates unnecessary trading entirely, since these funds always own everything.

As Vanguard's founder Jack Bogle likes to say, "Buy right and sit tight." To get a result as good as a pension fund would give, you must act as rarely and patiently as the best pension managers do and shun funds that think short term.

Thinking of retiring early? Money Magazine is looking to speak with people who would like to leave the workforce in the next few years but don't yet know what they'll do for health insurance (before they get to Medicare age). If that sounds like you, send your name, age, occupation, a brief description of your retirement savings and a photo to makeover@moneymail.com.

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