Are Mutual Funds A Relic?

By Tim Parker | February 03, 2012 AAA
Are Mutual Funds A Relic?

Even for those with little or no knowledge of the investment markets, "mutual fund" is a household term. Anybody with a 401(k) or other employee-sponsored retirement account probably has much of their money invested in mutual funds. However, just as the VCR was replaced by the DVD player, the mutual fund faces some tough competition from new products.

See: Investing 101

What Is a Mutual Fund?
Think of a mutual fund as a bunch of people pooling their money together. With more money comes more investment options and greater diversification. A portion of your assets will be used to pay the person managing the money - transaction costs and taxes - so you, like with any business, hope that the profits outweigh the expenses. You could also sell shares of your new fund to other investors, making the pool of assets even bigger.

But do the gains make up for the expenses? One study found that when all of the expenses of the fund were subtracted from the profit, 80% of all mutual funds underperformed the overall stock market by an average of 2%.

On the other hand, you and your investing friends could have created an index fund that has very little expenses, and mirrors the performance of the market. This would have saved you a substantial amount of fees, making your fund underperform the market by far less than 1%. (For more from a pro-mutual fund perspective, check out Advantages Of Mutual Funds.)

The Exchange-Traded Fund
Similar to a mutual fund, investors purchase shares in a fund that holds a collection of assets, but unlike a mutual fund it trades like a stock. Because exchange-traded funds (ETFs) normally track the price of the underlying assets they hold, there is no need for a high priced stock picker to manage the ETF. The fees that you pay for an ETF are lower than actively managed mutual funds without a loss in performance due to the expenses of the fund. Also, unlike mutual funds, ETFs don't have fees for entering and exiting the fund, advertising fees or commissions to brokers.

Are Mutual Funds a Relic?
Baby boomers are approaching retirement age only to find that they aren't financially well off as they had hoped. The mutual funds contained in their 401(k)s didn't produce enough income to allow them to retire comfortably. With the alarm sounded, younger investors are looking for other options.

Because 401(k)s and other retirement vehicles only allow participants to invest in mutual funds, unless the fund has a self-directed option, finding the most efficient fund is the key to getting maximum efficiency. Like an ETF, index mutual funds are passively managed funds with low expenses. These funds are increasing in popularity as actively managed funds continue to underperform.

For those with money to invest outside of their company-sponsored retirement vehicles, ETFs are quickly replacing mutual funds due to their lower fees, tax efficiency and liquidity.

The Bottom Line
As new products come to the market, people mistakenly believe that because it's new, it must be better. The mutual fund is far from being a relic, but the funds without large returns to justify the high fees they're charging are rapidly falling out of favor with sophisticated investors. Paying fewer fees for better performance is most important, regardless of whether the product is an ETF or a mutual fund. (For more on the debate between the two funds, check out The Future Of Mutual Funds.)

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