MOST INVESTORS LOOK AT THE disappointing past returns of mutual funds as a group and think, “Sure, but I’ll select only good performers!” Sounds easy, but selecting winning funds in advance is more difficult than it looks. Yes, there are always some winners that survive over a quarter- century, but not very many. But if we pore over records of past performance, it is easy to find them.

The mutual funds that we hear the most about are those that have lit up the skies with their glow of past success. We don’t hear much about those that did well for a while—even for a long while—and then faltered. And when they falter, they often go out of business—liquidated or merged into other funds. Either way, they vanish, consigned to the dustbin of mutual fund history.

But easy as it is to identify past winners, there is little evidence that such performance persists in the future. Let’s first consider the records of funds that have won over the very long term. Exhibit 10.1 goes back to 1970 and shows the 46-year records of the 355 equity funds that existed at the start of that period. The first and most obvious surprise awaits you: fully 281 of those funds—almost 80 percent— have gone out of business. If your fund doesn’t endure for the long term, how can you invest for the long term?

A fund failure rate of almost 80 percent.

You can safely assume that it was not the best performers that have gone to their well-earned demise. It was the laggards that disappeared. Sometimes their managers moved on. (The average tenure of active equity fund portfolio managers is just under nine years.) Sometimes giant financial conglomerates acquired their management companies, and the new owners decided to “clean up the product line.” (These conglomerates, truth be told, are in business primarily to earn a return on their capital as owners of the fund’s management company, not on your capital as a fund owner.) Often investors fled funds with lagging performance, the funds’ assets shrank, and they became a drag on their managers’ profits. There are many reasons that funds disappear, few of them good for investors.

But even funds with solid long-term records go out of business. Often, their management companies are acquired by marketing companies whose ambitious executives conclude that, however good the funds’ early records, they are not exciting enough to draw huge amounts of capital from new investors. The funds have simply outlived their usefulness. In other cases, experiencing a few years of faltering performance does the job.

A death in the family.

Sadly, a bit over a decade ago, the second-oldest fund in the entire mutual fund industry was a victim of these attitudes, put out of business by the new owner of its management company. Even though the fund had survived the tempestuous markets of the previous 80 years, it died: State Street Investment Trust, 1925–2005, R.I.P. As one of the longest-serving participants in the fund industry, who clearly remembers the classy record of this fund over so many years, I regard the loss of State Street Investment Trust as a death in the family.

The odds against success are terrible: Only two out of 355 funds have delivered truly superior performance.

In any event, 281 of the equity funds that existed in 1970 are gone, mostly the poor performers. Another 29 remain despite having significantly underperformed the S&P 500 by more than one percentage point per year. Together, then, 310 funds—87 percent of the funds among those original 355—have, one way or another, failed to distinguish themselves. Another 35 funds provided returns within one percentage point, plus or minus, of the return of the S&P 500—market matchers, as it were.

That leaves just 10 mutual funds—only one fund out of every 35—that outpaced the market by more than one percentage point per year. Let’s face it: those are terrible odds! What’s more, the margin of superiority of eight of those 10 funds over the S&P 500 was less than two percentage points per year, a superiority that may have been due as much to luck as to skill.

The Magellan Fund story.

That still leaves us with two solid long-term winners that outpaced the S&P 500 by more than 2 percentage points per year since 1970. Allow me to salute them: Fidelity Magellan (+2.6 percent per year versus the S&P 500) and Fidelity Contrafund (+2.1 percent).

It is a tremendous accomplishment to outpace the market by more than two percentage points in annual return over almost half a century. Make no mistake about that. But here a curious—perhaps obvious—fact emerges. Let’s examine the records of those two funds and see what we can learn.

Exhibit 10.2 charts the growth of Magellan’s assets (shaded area) and its return relative to the S&P 500 (black line). As the line rises, Magellan is outperforming the index; as it falls, the index is winning.

Star fund manager Peter Lynch ran Magellan during its heyday (from 1977 through 1990). Since then, five different managers have run the fund as well.¹ But more than manager skill (or luck) is involved here. Magellan’s staggering asset growth must also be taken into account.

Its greatest gains were achieved shortly after Magellan began with assets of just $7 million. In those early days, the fund outpaced the S&P 500 by an astonishing 10 percent per year (Magellan 18.9 percent, S&P 500 8.9 percent). After the fund’s assets passed the $1 billion mark in 1983, the fund’s superiority over the market continued, albeit at a lower, yet still impressive rate of 3.5 percent per year (Magellan 18.4 percent, S&P 500 14.9 percent) until the fund’s assets hit the $30 billion mark in 1993.

While the fund continued to grow, topping off at a year-end high of $105 billion in 1999, its relative outperformance failed to persist, losing to the S&P 500 by 2.5 percent per year (Magellan 21.1 percent, S&P 500 23.6 percent) from 1994 through 1999.

The fund’s underperformance continued after the turn of the century, trailing the S&P 500 by 1.8 percent per year (Magellan 2.7 percent, S&P 500 4.5 percent) even as its assets fell dramatically, from $105 billion in 1999 to $16 billion at the close of 2016, a drop of 85 percent. With money pouring into Magellan when it was “hot” and money pouring out when it turned “cold,” this may be the classic case of counterproductive investor behavior.

The Contrafund story.

The Contrafund story, so far, is not dissimilar to Magellan’s story during its first 30 years—great success followed by, well, reversion toward the mean. Will Danoff has been the lead portfolio manager since 1990. There’s no way to fault his remarkable achievement with Contrafund.

Prior to Danoff taking the reins, the fund outperformed the S&P 500 by 1 percent per year (Contrafund 12.6 percent, S&P 500 11.6 percent). Danoff has nearly tripled that annual advantage during his tenure through 2016 (Contrafund 12.2 percent, S&P 500 9.4 percent). (See Exhibit 10.3.) Yet reversion to the mean always strikes eventually. Over the past five years, Contrafund has underperformed the S&P 500 by minus 1.2 percent per year (Contrafund 13.5 percent, S&P 500 14.7 percent).

Yet success comes with its challenges. The fund’s assets totaled but $300 million when Danoff took over in 1990. In 2013, assets crossed the $100 billion threshold. In the three years since then, Contrafund’s superiority has vanished, losing to the index by 1.5 percent per year (Contrafund 12.8 percent, S&P 500 14.3 percent). The future: only time will tell.

When the reported investment returns generated by Magellan and Contrafund were noticed by investors, cash poured in, and they reached giant asset totals. But, as Warren Buffett reminds us, “a fat wallet is the enemy of superior returns.” And so it was. As these two popular funds grew, their records turned lackluster. While few actively managed funds will soon reach the mammoth size that Magellan—and even Contrafund—achieved, many, likely most, fund managers will face inflows when times are good and outflows when times are bad, a fundamental challenge to the industry’s sensitivity to fluctuating fund returns.

Living by the sword, dying by the sword.

Not all Fidelity funds survived the test of time met by Magellan and Contrafund. One example of failure was Fidelity Capital Fund, formed in 1957 and one of the stars of the Go-Go era. During 1965–1972 its cumulative return totaled 195 percent versus 80 percent for the S&P 500. Yet, in the bear market that followed, the fund fell by 49 percent (the S&P 500 fell by 37 percent). A few years later, its assets down from $727 million in 1967 to $185 million in 1978, it was merged into another Fidelity fund. “If you live by the sword, you die by the sword.”

Look (forward) before you leap.

But enough of the past. Let’s talk about the future. Before you rush out to invest in Magellan or Contrafund because of their truly remarkable long-term records—outpacing the returns of the S&P 500 by two and a half to three times despite their faltering in later years—think about the next 10 years, or more. Think about the odds that a winning fund will continue to outperform. Think about the fund’s present size. Think about the reality that over 25 years the typical fund will replace its managers three times. Think about the likelihood that even a single investor has actually held shares of the fund throughout its lifetime. Think, too, about the odds that a given fund will even exist 25 years hence.

Be equally skeptical of any mutual fund that has achieved superior relative returns over a decade or more in the past. It is a changing and competitive world out there in mutual fund land, and no one knows what the future holds. But I wish the very best of luck to the string of portfolio managers who will follow the present manager—and to the shareholders of the funds they run. Whatever you decide, please don’t ignore one of the least understood factors that shape mutual fund performance: reversion to the mean. (The remarkable power of RTM will be explored in more detail in the next chapter.)

Don’t look for the needle, buy the haystack.

The odds in favor of your owning one of the only two mutual funds (out of 355) with truly superior long-term records were just one-half of 1 percent. However one slices and dices the data, there can be no question that funds with long-serving portfolio managers and records of consistent excellence even over shorter periods are the rare exception rather than the common rule in the mutual fund industry.

The simple fact is that trying to select a mutual fund that will outpace the stock market over the long term is, using Cervantes’s formulation, like “looking for a needle in the haystack.” So I offer you a cautionary corollary: “Don’t look for the needle in the haystack. Just buy the haystack!”

The haystack, of course, is the entire stock market portfolio, readily available through a low-cost index fund. The return of a low-cost index fund would have roughly matched or exceeded the returns of 345 of the 355 funds that began the 46-year competition described earlier in this chapter—64 of the 74 funds that survived the long period, plus the 281 funds that failed. I see no reason that such a broad market fund tracking the Standard & Poor’s 500 Index cannot achieve a roughly commensurate achievement in the years to come—not through any legerdemain, but merely through the relentless rules of arithmetic that you now must know so well.

Indexing for a lifetime. Two major options: Investing in 30 or 40 active funds and managers, or in one index fund with one non-manager.

Look at it this way: If you’re investing for a lifetime, you have two basic options. You can select (as is typical) three or four actively managed funds and hope you select good ones, knowing that their portfolio managers, on average, are likely to last only about nine years, and that the funds themselves are apt to have a life expectancy of little longer than a decade.

Result: You’ll own maybe 30 or 40 funds over your lifetime, each carrying that burden of fees and turnover costs. Or (no surprise here) you can invest in a low-fee, minimal-transaction-cost, broad-market index fund, with the certainty that the same non-manager will still closely track its index for the rest of your life. There is really no practicable way that a portfolio of actively managed funds will serve you more effectively and consistently than the index fund. Simplicity, cost efficiency, and staying the course should win the race.

If you decide against indexing . . .

We know that the index fund will deliver substantially all of the stock market’s return. As to the actively managed fund, we know that fund manager changes will inevitably be forthcoming. We know that many of the funds (and, alas, many of their managers) will die. We know that successful funds will draw capital in amounts that are likely to jeopardize their future success. And we accept our inability to be certain how much of a fund’s performance is based on luck and how much on skill. In fund performance, the past is rarely prologue.

There is simply no systematic way to assure success by picking the funds that will beat the market, even by looking (perhaps especially by looking) to their past performance over the long term. It is like, yes, looking for a needle in a haystack, and with no better odds for finding one.