| Why are Most Mutual Funds Bad Investments? | | | | couple years you will have to pay the capital gains |
| Most actively traded mutual funds are poor | | | | taxes on these gains, even if the fund is flat and |
| products from the investor's point of view. This | | | | you never make a dime. Those embedded gains |
| may come as a surprise to many people since | | | | were actually experienced by the prior owners of |
| mutual funds are the primary investment product | | | | the fund (not you). Most people do not realize this |
| for most individual investors and they are very | | | | fact about mutual funds. |
| heavily advertised. Professional institutional | | | | 5. You can't predict which funds will be the best |
| investors rarely use active mutual funds. There | | | | performers and "beat the market" ahead of time. |
| are a number of problems with most active | | | | According to numerous statistical studies, past |
| mutual funds such as: | | | | performance is not an indicator of future |
| 1. They have high costs. The average active | | | | performance. Funds which have the hottest |
| equity mutual fund has an expense ratio of over | | | | recent records are not likely to continue to |
| 1%. In addition to this, there are trading costs | | | | provide the best returns, contrary to popular |
| that may subtract as much as .5% from | | | | opinion. Funds which have good performance |
| performance each year. I'm not even counting | | | | gather assets at a rapid rate, making it much |
| "sales loads" on some funds of 5% or more | | | | more difficult for the portfolio manager to |
| which I hope you aren't paying. How high are the | | | | continue to perform well. In addition, funds with |
| expenses on your mutual funds? I hope not 1% | | | | strong recent records are often just lucky to |
| or more. These expenses can eat up 25%-40% | | | | have been in the hottest part of the market or |
| of your total returns and can end up costing you | | | | the "in" style. Buying last year's winners is usually |
| a fortune over 10-20 years (due to compounding). | | | | a poor strategy which often results in buying |
| 2. Most mutual funds underperform the market. | | | | future laggard funds. You may recall how most of |
| This is primarily due to their high expenses | | | | the risky technology/internet funds had the best |
| mentioned in point #1 above. According to Lipper, | | | | recent track records and the highest Morningstar |
| Inc. over the past 20 years the average US | | | | ratings at the peak of the stock market bubble. |
| stock fund lagged the market by about 2% per | | | | They subsequently provided horrible losses to |
| year. The true track record is actually noticeably | | | | investors. |
| worse than this due to "survivorship bias". | | | | 6. The Portfolio Managers keep changing, and they |
| Survivorship bias occurs when poorly performing | | | | are too short-term oriented. Portfolio manager |
| funds are closed or merged (with better | | | | turnover (on each mutual fund) averages about |
| performing funds) and are not counted in this | | | | every 5 years now. So even if you fund a fund |
| data. The actual data including all funds (including | | | | and a manager you like with a good track record, |
| the closed/merged funds) is probably another | | | | chances are the same portfolio manager will not |
| percentage point worse than the number | | | | be there for long. |
| mentioned above. Over 10 years or longer it is | | | | 7. Portfolio Managers often drift from the |
| typical that 75% (or more) of all active mutual | | | | strategy they are supposed to be following. They |
| funds lag the market. The mutual fund firms | | | | tend to drift towards whatever has been working |
| promote their recent "winner" funds so much that | | | | lately (by adding more mid-size companies or |
| you would think all funds beat the market (which | | | | international stocks to a large-company portfolio) |
| of course is impossible). | | | | to try to add to performance. The problem with |
| 3. They are tax-inefficient. Most active mutual | | | | this is you don't really know what you are getting |
| funds have fairly high turnover (around | | | | when you invest in the fund. You think you have |
| 40%-100% per year on average), causing | | | | a large company domestic growth fund when in |
| short-term and long-term gains which are taxable | | | | reality a significant percentage of the fund may |
| each year. This causes some of the return (the | | | | be invested in other sectors or countries. |
| short-term gains) to be taxed at very high | | | | 8. Mutual fund companies are at least as |
| ordinary income tax rates. It also prevents the | | | | concerned about marketing and making money |
| power of compound returns from providing | | | | for themselves as they are about investment |
| maximum power by constantly taking gains and | | | | performance for shareholders. |
| paying taxes each year. When you own mutual | | | | So if active mutual funds are often poor |
| funds, you do not control the timing of taking | | | | products, what is an investor to do? I |
| capital gains (or not taking them). | | | | recommend and invest in ETF's (Exchange Traded |
| 4. You may inherit capital gains and owe taxes on | | | | Funds). These are similar to low-cost index funds, |
| gains you never actually experienced. Does that | | | | but they trade like stocks. ETF's are one of the |
| seem fair? If you buy most active funds after a | | | | fastest growing investment products and have |
| big upward move in the market, you will inherit | | | | been used by professional investors (like myself) |
| the gains in the stocks in the fund. Over the next | | | | for many years. |