Broker Check

9 Reasons to Avoid Mutual Funds

April 26, 2018
Share |

Let me start by saying this: not all mutual funds are bad. However, it takes effort to decipher the good from the bad. The financial industry has done an excellent job of selling the ease of investing in mutual funds and an even better job of hiding their deficiencies. Behind the scenes, we call them relics because mutual funds exist in a shroud of secrecy in a financial world that is crying out for more transparency. These dinosaurs could be on the verge of extinction.

 

Modern, more sophisticated investors, we believe, will seek out alternatives to the archaic mutual fund world. Cost is a significant driver of the current change we see in the financial and banking industry. Cost, however, is not the only problem in the mutual fund world. Other key drivers of change are transparency and honesty. We teach this to our kids and expect it from our other relationships in life, so shouldn’t we demand it from the mutual fund companies that hold our hard-earned investment dollars? The answer is a resounding YES. This trend toward transparency has been in progress for better than a decade but sill not fast enough in our humble opinion. Below is an archaeological dig into the nine reasons for the extinction of the mutual fund:

1. Cost – The Higher the Cost the Less Potential Return.

  • Administration Fee – This helps to cover the general expense for the mutual fund to be in existence. This fee is to help the mutual fund family to pay their cost of doing business or as one fund family describes “these fees reflect the benefits of the shared resources of the firm.” Nice! This expense is listed in the prospectus.
  • Distribution Cost (12b-1 fee) – A shareholders portion for advertising expenses, marketing expenses, and commissions. This expense is listed in the prospectus.
  • Transaction Costs – Typically the largest hidden cost. The mutual fund company will tell you the turnover rate of the fund but not how much the turnover cost each fund shareholder. Keep in mind that as soon as the quarter is over, they have the cost information. They know the exact trades made on your behalf and how much those trades cost the fund. They simply will not make the information public. This expense is not listed in the prospectus.
  • Sales Charges – Unless you buy a “No-Load Fund,” you are paying a sales charge to cover the cost of your alleged unbiased advice from your broker. The “load” is the broker’s first-year commission. This fee is listed in the prospectus and is designated by share class. Different share classes have different costs; a fact left out by many a salesperson (i.e., your broker).
  • Payments to Broker-Dealers and Other Financial Intermediaries – “If you purchase shares of the fund through a broker-dealer or other financial intermediary (such as a bank), the fund and its related companies may pay the intermediary for the sale of fund shares; and related services. These payments may create a conflict of interest by the fund over another investment.” So, I copied this from an actual prospectus because it is that unbelievable. Just think, you are getting the “best-unbiased advice” that can be bought by a mutual fund company. What a joke!

2. The Big Tax Bill

The potential capital gains tax is based on the buy and sell dates of each investment within the fund. You pay the gain but do not get the loss to help your tax bill. The fund part occurs in a year where your fund loses money but generates a tax bill. The trading done within the fund created a taxable gain based on the holding period of the stocks while the calendar year performance created a loss. Did your broker call you to give you a heads up? Did he/she let you know that if you sell the fund before a certain date, toward the end of the year, you can avoid paying the tax?

3. What say you?

Mutual fund managers are not in the habit of calling you to discuss their investment philosophy and if changes should be made to better equip the fund to help with your situation. Well, not unless you have invested millions of dollars with them. What about the little guy? Sorry, only the biggest investors are worth the time of the mutual fund manager. Next time you talk with your advisor, ask for him to set up a phone meeting with the mutual fund manager. Let us know if you get a meeting.

4. Fund Names are for Marketing

Does this feel balanced?
The fund name, in many cases, tells you nothing about how your money will be invested. The name is designed to catch your attention and to persuade you to take a look. Don’t assume you understand what your money is doing based on the name. You must read the prospectus to determine how your money will be invested.

For example, if the fund name uses the word “Balance” in the title; one could reasonably conclude that money will be evenly distributed between stocks and bonds. The right action is to read the prospectus for the stated balance of the fund. If the prospectus indicates the maximum percentage of stocks allowed in the fund is 80%; that is NOT balanced! The potential risk is much greater than the balanced title would indicate.

5. How did the Risk of my Investment Strategy Change?

To begin with, each fund is classified by “style” so people can best determine where a fund might fit into a diversified investment strategy. Over time, many things change beliefs, opinions, the manager and the result. This is what we call style drift. For example, you invested in small-cap fund; however, over time, many of the companies have grown and are no longer small cap but mid-cap stocks. The manager does not get rid of them because the companies have performed. Now the fund is a small/mid-blend rather than a small cap fund. Your risk level is different, and you may have too much money invested in mid-caps. So much for diversification. This may not seem like a big deal but minor changes over time can turn into the elephant in the room.

6. The Fund Manager Merry-Go-Round

Manager turnover is a fact of life. When a manager leaves, so do the track record of the mutual fund.

Did you look at the returns of the fund before making the investment? Would you have invested your money if the track record had been “too new to tell?” Do you want the new manager to learn with your hard-earned dollars? To combat this problem, funds have been listing their manager as “Team.” Nice fix! Now you will never know whose track record you are basing your investment decisions on. This fix was not in your best interest. It was just a way to avoid the problem altogether. Don’t invest in “team”.

7. What Diversification?

This is one of our personal favorites. When someone tells me they are diversified because they own funds with dissimilar styles, we get a little chuckle. How do you know if you have overlap? If you have heard of overlap, then you probably know you can run an analysis to see how many of the same stocks are held by your different stock funds. This helps, but it certainly does not guarantee that overlap is eliminated. The overlap is based on the released fund information which is at the end of the previous quarter. You have no idea what stocks the funds currently own nor if any of your funds own some of the same stocks.

8. Too Big to Fail

Can a fund have so much money invested in it that it can no longer meet its objectives? Too little money and too much money can negatively impact the returns of the fund. The Peter Lynch story is a well-documented cautionary tale. Lynch was a victim of his own success. The better his returns, the more people threw money at his fund. This continued until the fund was so big he looked for investments that were outside of the stock world. He found junk bonds and when they underperformed, so did his fund. Lynch went from the penthouse to the outhouse.

9. Window Dressing

As discussed in point 7, funds only disclose what they own at the end of the quarter. Window dressing occurs when the manager sells out of stocks he/she does not want you to know they owned and purchases the stocks that have performed the best in the prior quarter. Sell your losers and buy the winners to make yourself look better. Window dressing is the more enjoyable way of saying “whip cream on a pile of poo.” You go to look at the fund: You are very impressed by the quality stock picking in the information released to the public. However, those same stocks could have already been sold, and other stocks purchased. This practice also adds to the transaction cost referenced in point 1.