It’s often said that the world of mutual funds, a cornerstone of many retirement plans, is fiercely competitive. By the close of 2014, the sheer number of mutual funds exceeded 20,000. Adding to this vast landscape are hundreds of exchange-traded funds (ETFs). While it’s true that many of these funds are managed by a few large firms, the investment industry can hardly be described as a monopoly. Investors are presented with a seemingly endless array of choices.
In many sectors, robust competition tends to benefit consumers. Consider the smartphone industry, where companies aggressively compete to develop user-friendly interfaces. If tech companies can simplify the complexities of billions of lines of code for everyday users, why hasn’t the financial world managed to demystify the often-perceived alchemy of investing?
The critical difference lies in our ability to evaluate investment decisions. After using a new smartphone for a few weeks, most users can confidently judge whether it was a worthwhile purchase. Investing, however, is vastly different. It can take years, even decades, to determine if an investment was truly wise. A low return could indicate a prudent, low-risk strategy, or it might signal a significant missed opportunity. By the time the true outcome is clear, it’s often too late to rectify poor choices. Investors are often left to live with the consequences of their past decisions.
Furthermore, the typical benefits of market competition often fail to materialize for investors with limited financial understanding. Instead of correcting biases, markets can sometimes exploit them. For instance, many investors tend to select mutual funds based on the previous year’s performance, despite widespread warnings against this practice. This behavior creates a “winner-take-all” dynamic, where top-performing funds attract the majority of investor capital. One might assume this encourages funds to strive for higher returns, which seems beneficial.
However, this dynamic can create a detrimental incentive for fund companies to engage in excessive risk-taking. Investors often make their investment choices once and leave their money untouched for extended periods. Recognizing this, the most profitable strategy for a mutual fund company can become simply taking on greater risks in pursuit of high short-term returns. Landing in the high-return lottery, even briefly, can attract a wave of new investors, generating fees for years to come. Large fund families can continuously launch new funds, each with varying risk profiles, effectively buying multiple lottery tickets. While some funds may underperform, the few that reach the top performance rankings can significantly boost the company’s overall profitability. For individual investors, however, this system can often be a losing game.
