I HATE MUTUAL FUNDS.
That’s a controversial opinion, I know.
After all, mutual funds are the primary way most Americans save for retirement. And they’re generally considered a safe and convenient way for individual investors to own a diversified portfolio.
But I’m here to tell you that mutual funds aren’t all they’re cracked up to be.
In fact, most are downright lousy investments… geared more toward enriching fund managers and retirement plan administrators than helping folks like you and me.
And today, I’m going to show you why.
Now, in simple terms, a mutual fund is just an open-ended investment vehicle that pools money from many investors to invest in a portfolio of stocks, bonds, or other assets. And this portfolio is managed by a registered investment adviser.
There’s nothing inherently wrong with this structure. However, in practice, there are four critical problems with most mutual funds:
- They charge high fees.
- They underperform their benchmarks and the overall market.
- They are tax inefficient.
- They are relatively illiquid and nontransparent
Let’s take a look at each of these individually.
The first (and arguably most important) problem with most mutual funds is their fees.
In short, while costs have generally been trending lower in recent years, most mutual funds still charge outrageous fees for what they offer.
According to the Investment Company Institute, the average mutual fund expense ratio was 0.71% last year. (That means that the fund charges you about $7 for every $1,000 invested each year you own it.) And many funds still charge two or three times more than that.
That may not sound like much, but it can really add up over time.
For example, let’s take a hypothetical investor who plans to invest $5,000 per year in a mutual fund for retirement. We’ll assume she can earn 7% a year in this fund — roughly the market’s long-term average annual return — and has 30 years until retirement.
Under this scenario, our investor would expect to have a little over $523,000 in her account at retirement.
However, this figure doesn’t include fees.
If she invested in a fund with an average expense ratio of 0.71% per year, her balance at retirement would drop from $523,000 to a little over $473,000. That relatively small annual fee resulted in a loss of 13% of her potential gains.
If the fund had a 1% expense ratio, she’d lose almost 18%. At 1.5%, she would lose 25%. And at 2%, she would lose nearly one-third of her potential gains to fees.
As you can see, the losses snowball quickly as the fees increase. And unfortunately, the actual returns would almost certainly be even worse than this projection.
That’s because the market doesn’t return 7% every year. This average return includes both winning and losing years. But mutual funds charge these fees in good years and bad years alike, which can reduce long-term returns even further.
But it gets even worse…
You see, the expense ratio isn’t the only fee funds charge.
Many funds also charge purchase fees, front-end and back-end “load” charges, redemption fees, exchange fees, and account fees. Each of these can add as much as 1% to 4% to the cost of buying or selling a fund. And again, funds charge these fees in good years and bad.
Unfortunately, high fees aren’t the only serious problem with many mutual funds.
One of the more recent studies, from S&P Dow Jones Indices, showed that 72.8% of all mutual funds underperformed their specific benchmarks over the past five years. And that figure goes up to 86% when looking back over the past 20 years.
That means less than one out of every five mutual funds met their investment objectives over the past 20 years. And again, this is before accounting for their often-excessive fees.
Even worse, research has shown that only two-thirds of the funds that outperform in a given year continue to outperform the following year. And that figure drops to just 5% by the year after that.
In other words, even if you’re lucky enough to find the one out of five funds that beats its benchmark this year, there’s very little chance it’ll continue to do so in the future.
The Tax Problem
Mutual funds also tend to be problematic when it comes to taxes.
If you buy an individual stock or bond, you must pay income tax each year on any dividends or interest payments you receive. But you won’t have to pay any capital gains taxes until you sell, and only then if you’ve made a profit.
The latter isn’t necessarily true if you buy a mutual fund.
Because of how these funds are regulated, you may have to pay capital gains taxes when other investors sell, even if the fund lost money and you haven’t personally sold any shares.
Illiquidity and Lack of Transparency
Finally, mutual funds tend to be less liquid and less transparent than other popular investments.
For example, while most securities trade at a range of prices throughout the day, mutual funds only trade at one price — the net asset value (“NAV”) of the fund — determined at the close of trading each day.
That isn’t typically a big deal, but it can cause problems during periods of market stress when many investors decide to sell at once.
In addition, mutual funds don’t have to disclose their holdings until the end of each quarter. That means mutual fund managers can buy virtually any asset they choose, as long it meets the general guidelines laid out in the fund’s prospectus.
Now, despite these shortcomings, I realize that mutual funds are the default investment choices for folks in the vast majority of 401(k) and similar retirement plans.
But if you’re among them, you likely still have some options.
First, many plans now offer low-cost index funds along with the traditional selection of mutual funds. If nothing else, simply switching out high-fee funds for a portfolio of these low-cost options (like I showed you in the “All Seasons” approach back in April) can make a huge difference in your results.
However, more and more plans are beginning to offer self-directed brokerage options as well.
And next week, I’ll show you how you can use these accounts to build your own high-performance, “DIY” mutual funds with zero fees.
In the meantime, I’d love to hear about your experience with mutual funds.
As always, I can’t personally respond to every letter, but I promise to read them all.