What's Wrong With Mutual Funds?

Why are Most Mutual Funds Bad Investments?

Most actively traded mutual funds are poor products from the investor's point of view. This may come as a surprise to many people since mutual funds are the primary investment product for most individual investors and they are very heavily advertised. Professional institutional investors rarely use active mutual funds. There are a number of problems with most active mutual funds such as:

1. They have high costs. The average active equity mutual fund has an expense ratio of over 1%. In addition to this, there are trading costs that may subtract as much as .5% from performance each year. I'm not even counting "sales loads" on some funds of 5% or more which I hope you aren't paying. How high are the expenses on your mutual funds? I hope not 1% or more. These expenses can eat up 25%-40% of your total returns and can end up costing you a fortune over 10-20 years (due to compounding).

2. Most mutual funds underperform the market. This is primarily due to their high expenses mentioned in point #1 above. According to Lipper, Inc. over the past 20 years the average US stock fund lagged the market by about 2% per year. The true track record is actually noticeably worse than this due to "survivorship bias". Survivorship bias occurs when poorly performing funds are closed or merged (with better performing funds) and are not counted in this data. The actual data including all funds (including the closed/merged funds) is probably another percentage point worse than the number mentioned above. Over 10 years or longer it is typical that 75% (or more) of all active mutual funds lag the market. The mutual fund firms promote their recent "winner" funds so much that you would think all funds beat the market (which of course is impossible).

3. They are tax-inefficient. Most active mutual funds have fairly high turnover (around 40%-100% per year on average), causing short-term and long-term gains which are taxable each year. This causes some of the return (the short-term gains) to be taxed at very high ordinary income tax rates. It also prevents the power of compound returns from providing maximum power by constantly taking gains and paying taxes each year. When you own mutual funds, you do not control the timing of taking capital gains (or not taking them).

4. You may inherit capital gains and owe taxes on gains you never actually experienced. Does that seem fair? If you buy most active funds after a big upward move in the market, you will inherit the gains in the stocks in the fund. Over the next couple years you will have to pay the capital gains taxes on these gains, even if the fund is flat and you never make a dime. Those embedded gains were actually experienced by the prior owners of the fund (not you). Most people do not realize this fact about mutual funds.

5. You can't predict which funds will be the best performers and "beat the market" ahead of time. According to numerous statistical studies, past performance is not an indicator of future performance. Funds which have the hottest recent records are not likely to continue to provide the best returns, contrary to popular opinion. Funds which have good performance gather assets at a rapid rate, making it much more difficult for the portfolio manager to continue to perform well. In addition, funds with strong recent records are often just lucky to have been in the hottest part of the market or the "in" style. Buying last year's winners is usually a poor strategy which often results in buying future laggard funds. You may recall how most of the risky technology/internet funds had the best recent track records and the highest Morningstar ratings at the peak of the stock market bubble. They subsequently provided horrible losses to investors.

6. The Portfolio Managers keep changing, and they are too short-term oriented. Portfolio manager turnover (on each mutual fund) averages about every 5 years now. So even if you fund a fund and a manager you like with a good track record, chances are the same portfolio manager will not be there for long.

7. Portfolio Managers often drift from the strategy they are supposed to be following. They tend to drift towards whatever has been working lately (by adding more mid-size companies or international stocks to a large-company portfolio) to try to add to performance. The problem with this is you don't really know what you are getting when you invest in the fund. You think you have a large company domestic growth fund when in reality a significant percentage of the fund may be invested in other sectors or countries.

8. Mutual fund companies are at least as concerned about marketing and making money for themselves as they are about investment performance for shareholders.