3 Reasons Why I Don’t Like Mutual Funds
During the 1900’s, the mutual fund revolutionized investing, allowing the middle class access to the investment markets. Their time has come…and gone. In the years ahead, the Exchange-traded fund (ETF) will assume leadership of the investment lineup. Today, I’m not going to cover ETFs, saving that discussion for another day. I am going to give you three reasons why I generally don’t like mutual funds, and try to avoid them at all costs.
- Mutual Funds are Expensive. Mutual funds can charge a variety of different fees to manage your money, including the fund expense ratio, turnover fees, and sales loads. The expense ratio compensates the managers for managing the investments, and covers administrative costs as well. According to fool.com, the average mutual fund sports an expense ratio of 1.5 percent. Generally, bond funds have the lowest expense ratios, and international and small cap funds have the highest. Turnover refers to the trading expenses incurred when a mutual fund buys or sells investments. These fees are not included in the expense ratio, and they are not disclosed in the fund prospectus. The rule of thumb in the industry is that for every 100 percent in turnover; add 1 percent to your expenses. Since the average mutual fund turns over 85 percent of their portfolio over each year, this increases your expenses by an additional 0.85 percent annually. It’s not uncommon to find an aggressive growth fund with 300 percent turnover. Last but not least, if you purchase a fund upon the recommendation of a financial advisor, you may incur a sales load as well to compensate that individual. The most common sales load today is a front load (known as A shares), which is a one-time up front charge as a percentage of your initial investment. For a stock fund, this load generally begins at 5.75 percent. For a bond fund, it starts at 4.75 percent. This fee declines as the amount invested increases. But to sum it all up, many investors pay 5.75 percent to invest in a fund, plus an additional 2.35 percent annually to stay in it. That adds up to a lot of money over time. Worst of all, the total dollar amount of expenses paid are not disclosed, so investors don’t know what they are paying.
- Mutual funds cannot be used in conjunction with options, or with stop loss orders. Being able to use put or call options allows an investor to protect his or her principle and possibly enhance returns. Stop loss orders allow an investor to specify a price to sell the investment at if it falls. Once the security declines to that price, a sell order is triggered and the investment will be sold at the next best available price. While options and stop loss orders are available on individual stocks and ETFs, they aren’t available with mutual funds.
- Many mutual funds are “closet” index funds. Index funds and most ETFs are passively managed, meaning that a portfolio of investments are purchased, and excepting the occasional rebalancing, held for the long term. Because of this low maintenance, their fees are generally much lower than mutual funds. I certainly don’t have a problem with mutual funds that charge a lot, if they outperform their peers over complete market cycles. But many try halfheartedly to beat their peers. Why is this? A portfolio managers’ compensation is tied to how they perform relative to a market benchmark, such as the Standard and Poor’s 500 Stock Index. If they make big bets on a small number of stocks, and they are wrong, their compensation will be much lower than if they simply keep pace with the market. They buy most if not all the stocks in the index, and adjust their portfolios minutely attempting to add value. For example, Apple comprises 3.08 percent of the S&P 500, and Microsoft comprises 1.75 percent. If the manager likes Apple, he may invest 4 percent in it. If he dislikes Microsoft, he may only invest one percent. At the end of the day, it doesn’t add much to the performance of the fund. But the higher expenses an actively managed fund charges over an ETF or index fund do. Why pay more for the same results?