Mutual funds have been around since the 1920s. Since then, they have grown exceedingly popular with the masses. However, high net worth individuals and sophisticated investors continue to choose individual stocks and bonds over mutual funds. Why do they make this choice? People who know a lot about investing know that individual stocks and bonds provide many advantages over mutual funds. Individual securities are often cheaper, more tax efficient, require less idle cash than mutual funds, and can be tailored to meet individual needs for income and growth.
The average annual expense for a mutual fund is very high, about 1.4%. This fee does not include sales charges or the costs incurred to trade securities within the fund, which may be quite high given how often most funds buy and sell securities. John Bogal, founder of Vanguard Funds, estimates that the total annual cost is closer to 3%. If you work with an advisor who invests your money in mutual funds, you have to pay the advisor’s fee on top of the fund fee, and this can get very expensive. To keep costs low, large investors most often prefer individual stock and bond portfolios. But smaller investors can take advantage of these cost savings as well. (See Individually Managed Portfolios Not Just for the Super Wealthy in our October 2003 newsletter).
Funds are required to distribute 90% of their realized gains annually (gains from securities sold within the fund during the year). Their unrealized gain (the gain on securities still held) will be distributed to whomever holds the fund when the securities are sold. Every mutual fund has some amount of unrealized gain. If you buy a fund holding IBM, which the fund bought at $40 per share years ago, and IBM is now trading at $85, you are acquiring a portion of the $45 taxable gain per share of IBM the fund owns. This built-in tax liability can increase your taxes.
Individual stocks allow for much greater control over your taxes. You will only have to pay taxes on the gains you earn, and you can often sell other securities in the portfolio at a loss to offset some of these gains. You also control the timing of your gains and losses. This enables you to spread a particularly large gain over multiple tax years and delay taxes for a long period of time.
Mutual funds must set aside some cash to honor redemptions. Since fund managers cannot anticipate the quantity of redemptions that may be requested, the amount of cash left idle is often quite high, 5-10% or more. Keep in mind you pay the fund fee on all the money you have in the fund, even though not all of it is being invested.
With a portfolio of individual securities, the only withdrawals you have to worry about are your own. Since those redemptions are fairly easy to anticipate, you do not have to leave unnecessary cash sitting idle. With more of your money invested, you can achieve greater returns over time.
With a portfolio of mutual funds you often end up with overlap (the same stocks being held by more than one mutual fund that you own) and style drift. Many mutual funds may state their investment style, such as small cap value or large cap growth, but will allow the manager latitude to invest in other asset classes as well. This allows funds to drift away from their stated objective. The result is that your overall portfolio of mutual funds may not have the asset allocation you thought you purchased. This was very prevalent in the late ’90s when many fund managers chased technology as they came under pressure to increase fund returns. When technology crashed, investors found out their funds had become too heavily weighted in technology and they got burned.
When you invest with individual stocks, you know exactly what you own. Therefore, calculating the percentage of your portfolio that is in small caps or foreign stocks, technology or banking, is easy. This helps you maintain the proper diversification and asset allocation to meet your growth or income needs.
From the financial advisor’s perspective, mutual funds are far easier to use in managing clients’ money. Perhaps that is why so many advisors use them. Using individual stocks in a portfolio requires much more work. BWFA devotes many hours and dollars on independent research to maintain our buy lists. We are constantly making sure the portfolio is suitable to the needs of the client. Why do we do business this way? Just like the large investors of old, we know that portfolios of individual securities offer the best solution for our clients.