Investing in the largest funds isn't the biggest mistake you can make

Buying the largest and most popular stock funds isn't the worst decision investors can make, even if they're taking withdrawals. Unless, of course, they're buying those funds at the top of a bubble. The largest stock funds are big for a reason: They have good trailing track records. “A fund has gotten big by having had success,” said Todd Rosenbluth, director of ETF and mutual fund research at S&P Global Market Intelligence. Vanguard's gargantuan $465 billion Total Stock Market Index fund (VTSMX) has gained an average 7.7% a year for the past 15 years. The $109 billion Fidelity Contrafund (FCNTX) is up 9.54% a year the same period. First Eagle Global (SGENX), flying with $50 billion, has soared 11.38% a year. The problem with large funds — actively managed ones, at least — is that they tend not to be terribly nimble. Buying a 5% position in a $50 billion fund can take weeks or months to accumulate. Liquidating the position poses similar problems. On the other hand, large funds often have lower expenses than smaller ones, which is an enormous advantage in the long run. And fund companies that have large funds typically go to great lengths to make sure that they have top-rate managers. Consider the 10 largest funds of 1986 (see chart below). At the top of the heap was the Fidelity Magellan, whose manager, Peter Lynch, had run the fund since April 1997. The fund had a whopping $6.5 billion in assets in the third quarter of 1986. Its average annual return the 10 years ended Oct. 1, 1986: 33.03%, more than double the S&P 500's gain of 13.59% a year. In fact, nine of the 10 funds had beaten the S&P 500 during that 10-year period, with the exception of Templeton World, which made its debut in January 1978. As you can see, only three funds (Washington Mutual, Investment Company of America and AMCAP, all from the American funds) have beaten the S&P 500 the past three decades. None have been outright disasters, however, even for investors who were taking systematic redemptions. Taking regular redemptions from a fund tends to increase downturns in a bear market, and reduces gains in an up market. Let's consider investors who had followed a fairly common formula for withdrawals: Starting with a withdrawal equal to 5% of their investment and raising that withdrawal by 3% a year to account for inflation. All 10 accounts would still have money today. Assuming a $10,000 initial investment, an investment in Fidelity Magellan would be worth $62,662 today after withdrawals, and one in Vanguard Windsor would be worth $55,938. Even investors in the laggard Dreyfus Fund would have a bit of money — about $13,000 — left 30 years later. Investing in the largest funds and holding on isn't a complete disaster when the stock market is on the eve of a colossal meltdown — as it was in March of 2000. The S&P 500 has eked out a 4.33% average annual gain since then, according to Morningstar: Four of the 10 largest funds in 2000 have outperformed the S&P 500, and all have positive returns. Taking withdrawals from those funds, however, was often a disaster. Using the same procedure as above, investors in six out of 10 of the largest stock funds of 2000 would have run out of money by now. If you're a buy-and-hold investor, you get some credit for sticking with funds for the long term, said Mr. Rosenbluth. “You didn't bail out of the funds over multiple corrections and bear markets,” he said. Investors in those funds would have endured the Crash of 1987, the tech wreck in 2000 and the financial crisis of 2008. The one other lesson to learn: In most cases, you would have been better off in an index fund. No index fund will beat the S&P 500 — after all, index funds have expenses, too — but the best actively managed funds of the day rarely beat the index. “If the goal is to outperform, it's remarkable how few actually do,” Mr. Rosenbluth said.