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Mutual funds: Not quite as bad a deal as we thought

June 27, 2012: 6:00 AM ET

Actively managed funds add value, but most of it may go to the managers' retirement funds, not yours.

Legg Mason's famed manager Bill Miller, who recently called it quits

Fortune -- A new study suggests that investing in mutual funds might not be a waste of money. It's lowly praise, but it's a better review of the popular investment vehicles than they have recently been getting.

The prevailing view these days puts the average mutual fund manager somewhere between dope and charlatan. Critics have long contended that individuals would be better off in an index fund, which blindly invests its money in say the S&P 500, rather than going with one of the thousands of funds that try to pick individual stocks.

MORE: Is your 401(k) ripping you off?

Last year, for example, 84% of mutual fund managers failed to best a similar index. Even on Wall Street, indexing seems to be winning more of the day. In the past few years, more and more money has been going into ETFs and other funds that tend to track indexes.

But has the criticism of mutual funds gone too far? Perhaps. The new study, which was released this week by National Bureau of Economic Research, finds that a lot of mutual fund managers do earn their keep. And funds that do well tend to stay hot for a while. What's more, individuals seem to do a pretty good job of picking the funds that will be the winners.

MORE: 4 ways investors can still find yield

The problem is this is not as great news for fund investors as it appears. Unlike other studies, Measuring Managerial Skill in the Mutual Fund Industry asset-weighted mutual fund returns. So gains and losses at larger funds entered more into the calculations of the two co-authors, two economics professors, one from Stanford and the other from Kellogg's graduate business school, than smaller funds. And larger funds, had a tendency to outperform their index, or at least underperform less, than smaller funds. So while the study did find that the majority of the funds, 57%, tended to lose money relative to index funds, overall, the average mutual fund manager, propelled by the returns of the larger funds, added value.

The fact that individuals were able to pick the funds that would do better than average was also a mix blessing. The study found that those funds, recognizing their superior performance, usually increase their fees, quickly erasing any gain individuals got from selecting the better managers. "There are a lot of people who say active management is bad deal because investors have to pay a fee," says Jonathan Berk, teaches economics at Stanford University's graduate school of business. "What we found is that managers do make the fee up with their skill, and then take it away in compensation. So investors should be indifferent."

In the end of the day, the study may do a better job of explaining why tens of thousands of mutual funds still exist. But it doesn't really offer a compelling reason to put your money in them. Pick correctly, which many may do, but certainly not everyone, and actively managed funds aren't any worse than an index fund. So in the best case scenario, selecting an actively managed fund is a waste of time, though perhaps not money. How's that for a ringing endorsement.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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