I came from a generation that believed mutual funds were run by real experts like John Templeton, who did tons of research, made spectacular investments, and allowed the little guy like me to benefit from the results – for a fee, of course. For many years that was true, but our investment team has convinced me that I need to rethink my firmly ingrained beliefs. Let’s take a look behind the curtain.

Most Mutual Funds Cannot Beat the S&P 500

Over the last five years 65.44% of active, large-cap fund managers failed to outperform the S&P 500. Nevertheless, paying management fees to a mutual fund is not always a bad idea. Not all funds are stock funds designed to grow and beat the S&P 500. If you want a fund for specific reasons – like being more defensive or having specific diversifications, or maybe you want a bond mutual fund – then beating the S&P 500 may not be your primary goal. Comparing these types of funds to the S&P 500 misses the point.

If, however, you are investing in a diversified portfolio of equities for growth, then the comparison to the S&P 500 makes sense. It is a tough challenge for a fund manager to not only beat the S&P 500 consistently, but to also beat it by a wide enough margin to cover their management fees. You might just be better off in an ETF like SPY that mirrors the S&P 500 with lower costs to the investor.

This might mean you miss out on a mutual fund that performs better, but it will probably just keep you away from funds that can’t get the job done. Frankly, at this point in life protecting our nest egg trumps reaching for the remote possibility of higher yields from funds that have not performed consistently.

At the same time, when it comes to investing in bonds, a good fund with a low expense ratio makes a lot of sense. A person with $10,000 to invest puts his money at greater risk if he invests all $10,000 in a single bond than he would with a bond fund. First, if he wanted to sell a single bond, he might face some liquidity issues. And second, if there was a default, he could easily lose his entire investment.

The Optimal Way to Diversify

While mutual funds may technically be the optimal way to diversify – assuming they actually perform well – do we really need optimal diversification? Before you say to yourself, “Yes, of course; I want the best,” consider the following comments in the April 2013 issue of Money Forever:

“There is tons of academic research on optimal portfolio size and diversification, and what has been discovered is pretty dumbfounding. With a bunch of math and statistics, you can reduce the risk of your portfolio. Needless to say, it gets complicated.

But there is good news for retail investors. Academics have also found that owning 10 to 25 stocks has just about the same risk-reducing effect as the fancy math-based portfolios.

Depending on the study, the number may be slightly different (10-25), but they all conclude that after a certain point, owning another stock does little to reduce your risk – even if you’re using some impressive formulas. Being a math wiz only reduces your risk a tiny bit more.”

I have a friend who thinks investing in six mutual funds in different sectors keeps him protected. While it may give him some protection, how much does he really need, and is the cost worth it? Each fund lists its top ten holdings, plus it outlines the total number of holdings. Frankly, he could easily have positions in over 1,000 stocks, and he is paying significant fees that put him well beyond the point of diminishing returns. In short, mutual funds and ETFs can provide diversification, but at a certain point, it becomes overkill.

Management Fees Do Matter

A dear friend of mine works with a firm that charges him a management fee to invest his money in a basket of mutual funds. In his case, the funds are bond funds, so it would be unfair to compare the results to the S&P 500. His return last year was 6%, net of fees, which totaled 1.38%.

In effect the funds yielded 7.38%, which is quite good for a basket of bond funds. The funds had experienced some appreciation due to the drop in interest rates, but my friend cannot count on that to happen regularly. If interest rates stay the same this year, his yield will be lower. Should they rise, the net value of his investment will decrease.

While 1.38% in fees doesn’t sound too high, think of it from another perspective. My friend paid 18.7% of his return (that being 1.38% divided by 7.38%) – in a good year – for management fees. That makes the fees sound a bit steeper.

Furthermore, while the manager’s portion of the fees is 0.65% per year, which doesn’t sound like much at first, consider the following example. For the sake of simplicity, assume my friend has a $500,000 portfolio, which means that the 0.65% management fee adds up to $3,250 per year. That’s quite a bit of money, particularly when you think about how quickly it adds up over a five- or ten year period. If you’re still not convinced that fees matter, keep reading.

Would you like to be able to trade in your car and pay cash for a new one every five years? Maybe you’d prefer some other pricey toy, or a fancy vacation. It sure seems like investing directly could allow one to do just that; in the end, you’d have thousands of extra dollars at your disposal. While I understand paying for advice and education once, the fact that management fees are an annual expense is cause for concern.

Let me give you real number examples: the average US equity mutual fund’s annual expense fee is 1.43%. However, over the years investors have gotten smarter about fees. The average fee of mutual funds held by investors is 0.79% (of course, this does not include sneaky sales load fees that can be as high as 5.4%).

The fee range for the ETF options we recently reviewed in the May issue of Money Forever is 0.07% to 0.38%. If for example, you had $100,000 in a typical investor mutual fund charging 0.79% and you swapped it out for an ETF with a similar composition of stocks charging 0.07%, you’d save $720. That’s a 90% savings in fees for essentially the same performance.

For folks investing in mutual funds that deal with stocks, I suggest making the time to review your options. Unless you’ve found one of the few funds that consistently beats the S&P 500, are you really better off? After all, an educated investor can put together a safe, diversified, and profitable portfolio without loading up on high-fee mutual funds or paying someone annually to do it for them.

While we all know the phrase “penny wise and pound foolish,” we don’t want to be penny foolish either. If your portfolio is leaking pennies, the leak can quickly add up to a big loss. After all, $720 here and $720 there starts to become real money pretty quickly.

If a certain mutual fund is exactly what you want and there doesn’t appear to be a cheaper alternative, then go for it. However, do not make your choice based on past performance alone. More often than not, you can find a suitable ETF alternative with very similar holdings for a fraction of the fees. Plus, ETFs are generally much more liquid than mutual funds.

We recently published new report called “Top 10 ETFs to Replace Your Expensive Mutual Funds.” It’s dedicated to comparing mutual funds to ETFs, including the 10 top ETFs you should consider for replacing your expensive mutual funds. Chances are, you hold one or more of these expensive funds in your portfolio or retirement account right now, and you don’t even know how much they’re gouging you. You can get a copy of the report here.

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