Brian Tabb April 8, 2013

Abstract: The purpose of this research report is to inform the audience of index and mutual funds and whether or not they are worth the investment. Research was done to find specific graphs that illustrate how exactly mutual funds work. Looking at the results from what the graphs says, helped determine the usefulness of mutual funds. Establishing a difference between efficient diversification and diversification is reported. Also, explaining the usefulness in determining a funds alpha and what it means along with other investment type strategies were used to help make conclusions. As a result, this report argues for the fact that mutual funds are not worth the investment. With a little education and practice, investors should not need the help of a professional.

Table of Contents: Abstract Executive Summary Introduction Methods Results Conclusion Glossary References 2 4 4 5 6 8 8 10

List of Illustrations: How Many Stocks Make a Diversified Portfolio? Average Annual Returns for 10 sizebased portfolios, 1926-2007 Estimates of Individual Mutual Fund Alphas, 1972 - 1991 6

Executive Summary: Mutual funds are considered one of the safest ways to invest money, treasury bills not included. There has been a small movement towards investing in all types of mutual funds, whether it is money market funds, equity funds, or fixed-income funds. For the purpose of this report, the term mutual fund will be used in a broad sense, grouping all types into one. After analysis of said funds, it can be concluded that mutual funds are not worth the investment. Firstly, they do not provide a guaranteed return; in fact, on average, mutual funds have a minimal to zero return. Some casual investors can be mislead into thinking mutual funds have a guaranteed return due to the fact they are managed by professionals and highly diversified. Secondly, mutual funds are a collaboration of, more or less, randomly picked securities. Investors are then paying professional managers to pool a bunch of other investors money into one in order to get the high diversification. However, discussed in the report, this high diversification is not necessary. Efficient diversification is a more appropriate approach for investors. Lastly, anomalies overtime have continuously proven to be true, showing that the efficient market hypothesis is broken. Thus, mutual fund managers defense against poor capital gains (that markets are efficient) is disproven. Meaning, investors can use these anomalies to help make abnormal gains for themselves without professional help. Introduction: Since the recession in 2008, it still seems as if people are afraid of putting their money out in the market again. Some, ill advised, would rather put their cash under their mattress and, unknowingly, let inflation devalue their entire savings. All it really means is people want to find what is the safest or least risky way to invest. Thus, a lot of people are considering alternative ways for investing such as mutual funds and index funds. A mutual fund is a type of professionally managed collective investment vehicle that pools money from many investors to purchase securities.i The purpose of the professional manager is to take a pool of investors money and find a bunch of different stocks and index funds to help diversify the risk. There are a couple reasons that draw people towards mutual funds. First, some feel more comfortable putting their money in the hands of a professional. Second, investors in mutual funds can diversify their portfolio without having to spend a lot of money doing so. Diversifying a portfolio means spreading the risk through multiple industries and different securities. The risk an investor incurs buying one stock with Sonic, for example, can be huge. If the Sonic stock were to crash, then all of the investors money would crash as well. This would not be diversifying a portfolio. To start, the

investor would need to buy Sonic and 3M, for example, that way if Sonic were to crash, there is still a chance 3M will do well and counteract the crash of Sonic. Rather than two, the mutual fund managers buy hundreds of these stocks and other securities to help make the fund have as little risk as possible. An example of an index fund would include the S & P 500, Dow Jones, or any mutual fund. The attraction is diversification and professional management. But, as with other investment choices, investing in mutual funds involves risk. It pays to understand both the upsides and the downsides of mutual fund investing and how to choose products that match your goals and tolerance for risk (risk aversion). Many U.S. households rely on mutual funds to meet their long-term personal financial objectives such as preparing for retirement. Investors reactions to changes in U.S. and worldwide economic and financial conditions play an important role in determining how demand for mutual funds evolves over time. In recent years total net assets of all mutual funds has increased from $6,964.63 billion in 2000 to $11,621.60 billion in 2011.ii According to the same table, net assets of all mutual funds in 2008 were $9,603.65 billion and increased drastically to $11,120.15 billion in 2009. Investors have become more timid in their investments due to the affect of the 2008 recession. People do not want to see the value of their full life savings and retirement plans be cut in half again. This has pushed more people towards putting their money in professional hands. A professional manager of mutual funds uses the money that you invest to buy and sell stocks that he or she has carefully researched. Therefore, rather than having to thoroughly research every investment before you decide to buy or sell, you have a mutual fund's money manager to handle it for you.iii Methods: The methods used in this report were discovered in large by a 3-hour a week portfolio management class at The University of Tulsa. Also, the Internet was utilized as well to get additional information.

Results: Figure 1. How Many Stocks Make a Diversified Portfolio?

iv

The figure above illustrates the relationship between how many stocks an investor has in their portfolio versus the amount of risk attributed to said portfolio. The xaxis showing the number of stocks in the portfolio increasing as it moves right and the y-axis showing the average portfolio standard deviation (amount of risk is measured by standard deviation in this illustration) increase as it moves up. Thus, as the number of stocks increases in the portfolio, it is clear that the risk in fact keeps reducing. Mentioned before, efficient market hypothesis explains that prices of securities fully reflect available information about securities. Therefore, every security should be priced accurately based on all information about each security; thus, no capital gains can be made. However, certain anomalies have been proven to prevail continuously despite the efficient market hypothesis. One specific anomaly is called the smallfirm effect. This anomaly is demonstrated below:

Figure 2. Average Annual Returns for 10 size-based portfolios, 1926-2007

The figure above illustrates the returns of large firms and small firms by comparison. The number 10 represents the largest firm whereas the number 1 represents the smallest firm. There is a decreasing return the larger the company gets. Figure 3. Estimates of Individual Mutual Fund Alphas, 1993 - 2007

vi

The figure above shows mutual fund returns versus the S & P 500 index fund from the years 1993 to 2007. The mean of the results of alpha equals zero. The alpha of 7

a stock or mutual fund helps determine the amount of abnormal return earned on inefficiencies in the market. The alphas illustrated above correspond with entire mutual funds rather than a specific security. An alpha above zero would mean that the mutual fund beat the S & P 500. For example, if a mutual fund for the year had an alpha of 1, this would mean the mutual fund beat the S & P 500 by 1% and vice versa. Conclusion: As shown in figure 1, it is clear the risk reduces as stocks in a portfolio increase. However, investing in more than 5 or 6 stocks does not become worth it. For roughly the same amount of risk, a 5 to 6 stock portfolio becomes much easier to manage and track than a 30 to 100 stock portfolio gained with a mutual fund. Also, with investing in mutual funds, fees do apply. Mutual fund managers, roughly speaking, earn 1% of the total amount of assets in the portfolio. This may not seem like a lot of money, but mutual funds can carry up to trillions of dollars of assets and the only thing the mutual fund manager has to do is beat the market (any index fund can be considered the market S & P 500, Dow Jones Industrial Average, etc.). Therefore, 1% of 1 trillion dollars becomes 10 billion dollars that the mutual fund managers company earns; 10 billion dollars the mutual fund deserves but does not receive. As shown in figure 2, it is clear that it would be smart to invest money is smaller firms, thus getting the greater return. The thing to watch out for is the risk associated with such firm. Diversify a portfolio with smaller firm stocks and in different industries. Looking at figure 3, the numbers show the average return earned above the index, S & P 500, is zero meaning professional managed funds did not beat the market. Concluding that there is a high possibility that any person could have simply put their money in the market, let it sit there for a few years, not paid a service fee, and still beat a professionally managed mutual fund. Glossary: Abnormal Return: The return of a stock or portfolio greater than what was expected based on the Capital Asset Pricing Model (CAPM). Earning such return is done by either selling the stock when the estimated price is less than the current market price or buying the stock when the estimated price is greater than the current market price. Alpha: Return in excess of required return based on beta and the market return in each period. A positive alpha on a specific security denotes an underpriced security whereas a negative alpha on a specific security denotes an overpriced security. Anomaly: A pattern of return that seem to contradict the efficient market hypothesis. Beta: Is a quantitative measure of a stocks sensitivity towards a benchmark, usually the market. 8

Capital Gains: Return on investments. CAPM: Capital Asset Pricing Model-determines a theoretical required rate of return of a stock or any other asset. The model takes into account the assets sensitivity to the market, its market risk, represented by the Greek letter (beta). Efficient Market Hypothesis: The hypothesis that prices of securities fully reflect available information about securities. Index Fund: For the purposes of this report, a collaboration of multiple stocks from different industries that help establish market averages. Mutual Fund: A type of professionally managed collective investment vehicle that pools money from many investors to purchase securities. Passive Investing Strategy: A way to invest in the market. This strategy utilizes cash cows (big firms that have strong earnings year after year to pay a high dividend with low risk of going bankrupt). It is a sit-and-wait type strategy that, also, utilizes index funds with very little risk and managing usually resulting in subliminal returns. Risk Aversion: A number associated with the amount of risk tolerance a person has. A number close to 0 (zero) means that person is less risk averse. In other words, that person does not mind taking on more risk than, for example, a person with risk aversion number of 4. Securities: Is a tradable asset of any kind. Small-Firm Effect: Stocks of small firms have earned abnormal returns. Standard Deviation: In this sense, is a way to measure risk of a security. Standard deviation is the square root of variance in which a stock could potentially move towards based on macroeconomic factors. Treasury Bills: Similar to a bond, the difference is treasury bills are issued by the government and backed by the government. Therefore, if the government ends up not being able to pay their debt, they can print money to cover.

References: "Mutual Fund." Wikipedia. Wikimedia Foundation, 04 Aug. 2013. Web. 30 Mar. 2013.
i

"Data Tables." 2012 Investment Company Fact Book. 52nd ed. [Washington, D.C.]: Investment Institute, 2012. 134. Print.
ii

"The Advantages Of Mutual Funds." The Advantages Of Mutual Funds. N.p., 13 Mar. 2012. Web. 01 Apr. 2013.
iii

Statman, Meir. How Many Stocks Make a Diversified Portfolio? 1987. Photograph. Journal of Financial and Quantitative Analysis 22, n.p.
iv

Kenneth. Average Annual Returns for 10 Size-based Portfolios, 1926-2007. 2008. Photograph. Tuck School of Business, n.p.
v

Madhan. Estimates of Individual Mutual Fund Alphas, 1972 - 1991. 1992. Photograph. Collins College of Business, n.p.
vi

10