Each quarter, Standard & Poors published a report that compares the performance of professionally mutual funds with the performance performance of the S&P broad market indices. The report is called the S&P Indices Versus Active Funds (SPIVA) Scorecard. The S&P analysis shows that the most mutual funds fail to outperform the market indices. As the time horizon gets longer, the performance by the professional fund managers gets worse. The complete SPIVA can be found here.

Here are some details from the S&P report for the 4th quarter of 2006.In 2006, domestic equity stocks indices led actively managed large-cap and small-cap funds. The S&P 500 outperformed 69.1% of large-cap funds and the S&P SmallCap 600 led 63.6% of small-cap funds. Conversely, 53.3% of mid-cap funds outperformed the S&P MidCap 400.

Over longer time periods, the market indices continue to outperform a majority of the actively managed funds. Over the past three years (and five years), the S&P 500 has beaten 66.7% (71.4%) of large-cap funds, the S&P MidCap 400 has outperformed 65.1% (79.7%) of mid-cap funds, and the S&P SmallCap 600 has outpaced 80.6% (77.5%) of small-cap funds.

Why do the indices perform better than actively managed funds? The short answer is that fund fees are higher and many funds do not do a good job of selecting stocks or managing their portfolios. (Most funds are exceptionally good at collecting fees, however.) A number of funds fail to put the financial interests of their shareholders ahead of their own. (The recent after hours trading scandal by fund managers is one example. Another is excessive fees.)

Fees and expenses erode net return on mutual funds. Management fees typically range from 0.5% to 1.5%. (In contrast, management fees for some of the largest and oldest index funds are generally less than 0.2%.) In addition, mutual funds also pay various transaction transaction and portfolios. These fees are not disclosed in their prospecting but are contained in a statement of additional information. Some have high turnover of assets. High portfolio turnover raises expenses, increases tax liability, and often degrades performance.

When evaluating a mutual fund, it important to compare its performance to the index that most closely corresponds to the style of the fund (large cap value, mid cap blend, small cap value, etc.). Also keep in mind that index funds tend to be more tax efficient. Low turnover reduces the annual tax bite.

How do you know if the mutual fund you are considering buying is one of the few that has outperformed market? First, go to www.fundalarm.com and see how the fund has done over the past 1, 3 ,and 5 years. FundAlarm.com compares fund performance with the benchmark that most closely corresponds to the fund style. Second, look at the expense ration for the funds and sales commission. Morningstar also compares fund performance with an index benchmark. The management fee for a domestic equity fund should not exceeds 0.8%. Pass on any funds that charge a load or 12b1 fee.

So what relevance does this have to the Model Investment? First, it is not easy to beat the market. We try but do not always succeed. Second, it is important to minimize transaction fees and expenses.