Mutual funds experienced a surge in popularity from the 80’s and 90’s. In 2013, nearly half of all U.S. households owned mutual funds. It’s easy to see why mutual funds are so attractive: they’re easy to buy, they’re easy to sell and they offer instant diversification.
What are Mutual Funds?
A mutual fund is a professionally managed investment vehicle. A mutual fund pools money from investors and has a fund manager calling the shots behind the scenes. This makes a mutual fund an ‘actively-managed’ investment. Instead of managing your investment yourself, you hand over that responsibility to someone who is a professional with a proven track record of making money in the market. While it is tempting to think that a mutual fund is a hedge fund – that would be incorrect! Mutual funds are not hedge funds, because mutual funds can be sold to the general public, unlike hedge funds. The benefits of owning a mutual fund are two-fold. Investing in a fund managed by an investment professional saves you time, time that could be used to do the things you love. There’s often a peace of mind that comes with knowing your investments are in the hands of someone who knows what they are doing. Another benefit to investing in a mutual fund is that as a small investor, one can get access to professionally managed portfolios, through the fund manager, that you might not be able to have access to otherwise. Here’s how it works. You pick a fund you like and buy shares of said fund, then sit back and let the money manager pick the stocks he thinks will yield the best return. It’s almost always made up of a collection of stocks – instant diversification. If one stock goes bust, it shouldn’t affect the fund too greatly.
So, are mutual funds still a good investment?
On the face of it, mutual funds are an easy way to gain exposure, i.e. risk money in the markets, as well as being a way to diversify an already existing portfolio but here’s the dirty secret of mutual funds: most of them fail to beat the market. One 2010 study followed the performance of 2,076 actively managed mutual funds between 1976 and 2006. After accounting for fees, they found that 75% of them returned zero “alpha”, or return in excess of some benchmark, usually something that mimics the overall market such as the S&P 500. That does not mean the money managers didn’t make money for their investors, just that they could not beat the benchmark they were being measured against. Only 0.6%, showed any consistent returns in excess of the benchmark index. 0.6%, which is ‘”statistically indistinguishable from zero”, in the words of the researchers who conducted the study. So you’re unlikely to pick a mutual fund that will outperform the market, and the annual fees can really take a bite out of your return. The expense ratio fee, between 0.5 and 1.5%, is the fee the fund manager takes home. If you’re invested in a smallish mutual fund ($500 million) then the fund manager is taking home anywhere from $2.5 to $7.5 million! Take note: the average size of a U.S. mutual fund is 1.58 billion. Then there are administrative costs, and something called the 12B-1 fee, which uses the money accrued to pay off brokerage commissions as well as promoting the fund. You are essentially paying the fund to advertise itself so it can get more customers!
Then there are loads…
Loads are fees a fund uses to pay sales people or other intermediaries for selling you the fund. So say you bought a mutual fund with a 5% front-end load through your bank, Washington Mutual. You invest $1000, of which $50 goes to the bank and the rest is invested in the mutual fund. It’s called a front-end load because it happens before the money is ever invested. Back-end loads are more complicated. You may end up paying a back-end load fee if you sell the fund within a specified time frame, sometimes up to 7 years.
If you must buy a mutual fund, stick to a no-load fund. The lack of fees means more of your money is at work – an ideal scenario. Stick to discount online brokers and stay from fees!
What’s a guy to do?
Luckily, there are other options. You could invest in a very specific type of mutual fund: the index fund. Instead of being actively managed by an investment professional, index funds are a constructed to track some market index, for example: the Dow Jones. Index funds are a form of passive investment and the advantages are simple. You don’t have to worry about picking a money manager who will eventually lose you money. Just track the market and watch your money grow. You also get to save greatly on fees. Index funds are passively managed, so there are no “star” managers taking a cut of your hard-earned dollars. The fees on index funds are generally lower than 0.2%. The Vanguard 500 Index Fund (VFINX), which closely follows the S&P 500, has an expense ratio of just 0.17%. Buying a mutual fund is a sucker’s bet. “The fund industry costs investors billions in lost returns every year – while coining money for itself, its employees and its distributors.” Warren Buffett himself suggested that the common investor is better off invested in index funds. If you were to rank the top equity mutual funds in 2009 and look at the top 25% , as the research team at Standard & Poor’s did, and look at how that composition changed over time you would be very disappointed. Only 2 out of 2,862 funds managed to consistently outperform their peers over a 5 year period. What’s the chance the fund you picked was one of those two?
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