The Skeptic's Guide to Mutual Funds Strategies for investors who no longer believe that anyone--including financial journalists--can really predict which mutual funds will beat the market.
By Bethany McLean

(FORTUNE Magazine) – Is there any FORTUNE reader who doesn't own a mutual fund? Chances are that even the most devoted stock jockey has a big chunk of money in a fund--via a 401(k), if nothing else. Whether you love funds or hate them, they've become a financial fact of life. Since 1980 the number of equity funds has grown 11-fold, from 288 to 3,532, while assets have mushroomed from $44 billion to almost $3 trillion, says the Investment Company Institute. The average expense ratio of 1.5% (according to Morningstar) implies that investors are paying some $45 billion a year for the privilege of owning stock funds. Those dollars have built amazingly profitable companies (think Franklin Resources, which reported a 19% net profit margin last year) and created some extremely wealthy people (think of Mario Gabelli, who collected more than $42 million in 1998).

For fund shareholders, however, the return on that $45 billion has been notably skimpy. Up to 90% of your investment return depends on your own decision on how to divide your portfolio among stocks--both large and small--bonds, and cash. As Robert Gay, the former director of quantitative research at Donaldson Lufkin & Jenrette who's now the CEO of research firm GEARS, points out, buying a fund run by a brilliant stock picker will have far less impact on your finances than simply getting the asset allocation right. Not that there's much brilliant stock picking anyway. Fewer than 20% of all equity funds outperformed the unmanaged S&P 500 index in the past year. The percentage drops to 11% over ten years and to 4% over a 15-year stretch. And despite the solemn import that fund companies attribute to past performance, there's no evidence that the 4% who beat the index owe their record to anything other than random statistical variation. "The whole industry is built up around a certain degree of black magic," says one consultant.

This FORTUNE special report is designed for investors who aren't fooled by that old magic. In this story and those that follow, you will find no adoring profiles of the hot manager of the hour, nor any pseudoscientific analysis of fund track records. What we offer instead are strategies built mainly around index funds--that is, low-cost funds that mimic the performance of indexes like the S&P 500. Logic and experience show that such funds have a high probability of producing above-average future returns and, frankly, a near-zero chance of topping the charts. Maybe that's not as ambitious as naming "Five Hot Funds to Buy NOW," but it does have one advantage: It won't take a miracle for our advice to work.

Anyone contemplating an investment in equity mutual funds today has to start with this fundamental premise: After underperforming index funds for seven of the past ten years, active managers now bear the burden of proof. They have to demonstrate they can produce high enough returns to overcome expense ratios that typically run a full percentage point above those on index funds, as well as the additional transaction costs that come with active management. It's not an easy case to make. Today investing information is instantaneously dispersed everywhere. That makes it extremely difficult for equity managers, especially those who buy widely followed large-cap stocks, to gain an edge. Indeed, study after study shows that any value active managers do add is negated by management fees and transaction costs. "They can't beat the system," says financial planner Harold Evensky, who uses index funds for all his clients' domestic large-cap assets.

Many individual investors seem to have reached the same conclusion. David Master, a managing director at industry consultant Optima Group, notes that over the past four years Vanguard--the leading source of index funds--has taken in more net new cash than the industry leader, Fidelity. More and more index-whipped fund managers have thrown in the towel, as well. They now run their portfolios as virtual copies of the S&P, slightly overweighting certain stocks and underweighting others in hopes of stealing a point or two at the margin. "Many funds are closet indexers, but they don't want to bill themselves as such because they charge too much," says David Diesslin, a financial planner in Texas.

One thing to consider, though: The S&P is not necessarily the best index to follow. The core problem is its price. Martin Whitman of the Third Avenue funds notes that while the S&P 500's market value increased 17.9% annually from 1990 to 1998, its earnings per share grew at just a 7.3% rate. That's not sustainable. Part of what has driven the index to such heights is a passionate (but hardly permanent) infatuation with the handful of corporate giants that dominate the index. Indeed, Morgan Stanley Dean Witter strategist Leah Modigliani points out that just 15 stocks accounted for half of the index's returns in 1998.

A better alternative is funds that track the entire universe of domestic stocks via the Wilshire 5000 index. Although the Wilshire underperformed the S&P in 1998 (23.4% to 28.6%), the two indexes have identical annual returns over the past 25 years--16.1%. From 1975 to 1981, the Wilshire beat the S&P due to its exposure to small caps. Yes, the 500 big bruisers of the S&P still account for around 80% of the Wilshire. But it's significant that Gus Sauter, who runs Vanguard's equity index funds, says that sophisticated non-mutual fund investors--like pension plans--are net sellers of S&P 500 index funds and buyers of broader indexes.

Only when you get beyond big-cap stocks can you make a plausible case for active management. Smaller companies can more easily slip under Wall Street's radar, allowing an enterprising money manager to get information before the rest of the market. Thus, the chance that your manager can earn his pay is a little greater in this sector than in the large-cap arena.

Still, identifying winners in advance is a low-percentage game, even in this group. Despite volumes of research attesting to the meaninglessness of past returns, most investors (and personal-finance magazines) seek tomorrow's winners among yesterday's. Forget it. The conditions that made a fund great in the past tend to change. For one thing, success often brings a gush of money into a fund, forcing it to change its style. The only value past returns really provide is to flag losers. "If a fund's past returns are really bad, the manager probably isn't good," explains Mark Hurley, the CEO of fund company Undiscovered Managers. "If they're really good, you don't necessarily know what's going to happen."

That sort of skepticism about past returns is crucial. The truth is, much as you may wish you could know which funds will be hot, you can't--and neither can the legions of advisers and publications that claim they can. That's why building a portfolio around index funds isn't really settling for average (or a little better). It's just refusing to believe in magic.