In spite of the love affair that the press has with the mutual fund industry, fueled by huge amounts of advertising money thrown at the media to extol their virtues, it’s time to understand some significant facts about them, and the disadvantages of owning them for anyone who has over $300,000 to invest..
1. Mutual funds are expensive. Although the industry claimed that the increase in dollars in mutual funds would allow fees to come down, they didn’t. Why are there more mutual funds than stocks – because funds are enormously profitable for their sponsors. Be aware that expenses incurred to purchase securities in the funds (which may be considerable, due to very high “turnover” rates) are not included in the expense numbers published by the funds. They are more expensive than they appear to be.
2. They are interested in their performance, not yours. There is considerable pressure in the fund industry to achieve short term investment results, and the press (fueled by advertising dollars from the funds) is largely responsible for focusing investor attention on short term results. This leads to a high level of short term buying and selling, driving up expenses and driving down long term investment results.
3. You are buying a tax liability when you buy a fund. Funds are required to distribute 90% of their realized gains annually (gains from securities they actually sold during the year). Their unrealized gain (the gain on securities they haven’t sold yet) will be distributed to fund holders when they do actually sell securities with gains. The holders at the time of the sale will pay tax at that time. Unrealized gains in some funds are in excess of 30% of the value of each unit you buy. The Vanguard S&P 500 index fund has a 24% unrealized gain. Would you prefer to own IBM at $145 per share with or without a 30% tax liability? Also, returns published by the funds don’t consider the high tax effect of the way they are managed.
4. Funds have high “turnover” rates, which lower long-term after-tax investment performance. Estimates are that “turnover” (buying and selling of securities within the fund) average in excess of 50% industry wide. This means that within two years, every security in the fund will be sold, and replaced with another security. A large number of funds have turnover rates in excess of 100% annually (short-term performance orientation). Aside from lowering long run investment results, this practice increases your taxes in taxable accounts.
5. Mutual fund managers are forced to buy high and sell low. Have you ever wondered why 85% of the educated and highly competent stock fund managers fail to beat the market each year. It’s because they are always swimming against the tide. It’s the curse of their success. They are forced to sell in a down market (to meet redemptions), and they have to buy in an overpriced market when money flows into their funds, whether or not they want to. This is a formula for poor results.
Mutual funds have significant advantages for investors with $300,000 or less. They also make sense for certain niche securities, like high yielding bonds and foreign securities. The problem, as we see it, is that they have been “oversold” to many investors who are far better served by having a portfolio of individual stocks managed in an intelligent fashion. Individually managed portfolios are tailored to suit the needs of individual investors, not the needs of fund companies.