The case against mutual funds

By Markets Covestor

Given the cost-effectiveness of exchange traded funds (ETFs), does it make sense to own mutual funds in your portfolio?

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In our opinion, the answer is no.

 

 

Let’s take a look at a few facts:

Fees

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According to Fidelity Investments, the average equity mutual fund management fee is 1.4%, while the average ETF expense ratio was 0.6%.

 

Loads

If you pay a load (or sales charge) for a mutual fund that you purchase, that is essentially a sales commission to your financial advisor and reduces your portfolio’s performance.

In our opinion, investors shouldn’t invest in mutual funds that require a load. However, many advisors continue to recommend them.

 

Double Trouble

If your investment advisor has you invested in mutual funds, you may be paying a fee to your financial advisor plus the higher fees of the mutual fund.

Every investment advisor charges a fee. We do have to make a living.

But you may wonder why a financial advisor would have their clients invest in more expensive mutual funds when lower cost ETFs are available to everyone.

Let me give you a short example of why this occurs so often. Someone I know recently came into some investable money.

 

Bad Advice

He was referred to an advisor at a large firm and after a meeting was presented with a proposed portfolio comprised solely of mutual funds.

This person asked if I would speak with the advisor and ask some questions. I asked why no small cap funds had been selected.

I was told that they selected strong mutual fund managers and allowed them to make all investment determinations.

I asked why there were two senior bank loan funds.  I was told that it was for diversification, even though the two were very closely correlated and provided no actual diversification.

I asked why there was no exposure to commodities, other than gold. I was told that the mutual fund managers could create that exposure if they felt it was timely.

 

Client Comes First

I then asked what this advisor was being paid to do. He said that his firm devoted significant resources to evaluating and selecting the best mutual fund managers in the world.

I asked whether the advisor ever evaluated the holdings of these mutual funds or their exposure to various segments of the markets.  The response was an equally underwhelming: “We evaluate their track records.”

In my mind, this advisor does nothing more than select other people to manage money for their clients. If I am a client, I want to be able to pick up the phone and speak with the person who is actually managing my investments.

 

Performance

Numerous recent studies have concluded that only 24% of professional investors have outperformed the market over the past 10 years.

Standard & Poor’s found that 62% of all domestic equity mutual funds failed to beat their benchmarks over the prior five years as of December 31, 2012.

Vanguard, which even sells some actively managed mutual funds, found in a recent study that only 18% of mutual funds outperformed their benchmarks over the 15- year period ending December, 2012.

This study also made a few astounding findings: Some 97% of the outperformers experienced at least five calendar years in which they also underperformed their benchmarks and more than 60% had seven or more years of underperformance.

Secondly, of the 275 best performing funds in the study, 94% had at least three consecutive years of underperformance.

Most investors will sell a fund that has underperformed for three consecutive years so they never received the benefit of long-term outperformance.

To think that any of us can select one or more of the 18% of mutual funds that outperform over the long-term, and then avoid the 94% of that select group that underperformed for several consecutive years, is simply not realistic.

We believe that mutual funds are a losing game for investors but do earn a great deal of fees for mutual fund companies.







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Photo Credit: Chris Potter via Flickr Creative Commons