There is a common belief that investing in mutual funds is a conservative way to accumulate wealth in the stock market. We have all seen the cover of financial magazines that read: “Our 100 Best Mutual Funds for 2017.” Yes, magazine companies are in the business of selling their magazines.
If you are looking at whether or which fund to buy you usually look at its track record or performance history. Although we all know at the bottom of every mutual fund brochure is the disclaimer: "Past performance is not indicative of future results." Since most investors are dazzled by performance, I beg to differ. (For more, see: How Mutual Fund Companies Make Money.)
The first question should be: What are the costs? The annual cost of owning a mutual fund is called the expense ratio. There is also a separate charge called the sales load which I will cover later. The expense ratio is the percentage of the fund’s assets that go toward running the fund. But there are three additional components to be aware of:
- Management fees
- Administrative costs
- 12b-1 fees
Management fees or investment advisory fees go to pay the portfolio manager. You know it keeps up his Hampton beach house. Seriously, that is how he gets paid as well as from firm bonuses.
Administrative costs are for operating expenses like recordkeeping, client mailings, maintaining a customer service phone line, etc. These vary with the size of the fund.
Lastly, there is the 12b-1 fee. This fee is for marketing and advertising. Think about this fee when you see your fund advertised during Super Bowl half time. It also includes trailer commissions paid to the broker of record as an incentive to sell the fund. It works like an annuity for the sales person over the life of the fund. It is usually paid to the broker quarterly as it is taken out of the net asset value of the fund fractionally. I have even seen some funds that are closed to new investors and are still charging 12b-1 fees. (For more, see: 12b-1: Understanding Mutual Fund Fees.)
Regarding the sales load, mutual funds come in different share classes and this will determine whether you pay an up-front, back-end, contingent deferred sales load or no-load. The expense ratio usually differs with which share class you buy. Sounds confusing, doesn’t it? That is the way the mutual fund industry prefers it.
The bottom line is that these fees are rising as funds shift away from the up-front loads that are driving away sales and into the annual expense ratios where they are not as detectable. And these fees are charged every year whether or not the fund has performed. I have seen mutual fund holdings that have been held for years and the only one who has profited is the mutual fund company.
The other issue with mutual funds is the high turnover of assets in the fund. Buying and selling stocks have transactional costs which cut into the net return. A fund with a high turnover will end up distributing yearly capital gains to their shareholders and that will generate a tax bill for the investor thereby reducing net returns.
Additionally, mutual funds are required to maintain liquidity and the capacity to accommodate withdrawals. Funds typically have to keep a portion of their portfolio as cash. The funds are keeping cash balances of usually around 8% of the fund, which is not generating any returns. The average fund is charging around a 1.5% expense a year on the 8% that it is keeping in cash.
Mutual fund companies aggressively market funds awarded 4 or 5 stars by rating agencies. But the rating agencies merely identify funds that have performed well in the past. It provides no help in finding future winners. Historically, mutual funds have not outperformed the market. Research indicates that around 72% of actively-managed large cap funds failed to outperform the market over the last 5 years.
Mutual Fund Alternatives
There are alternatives to mutual funds that are structured differently and will also give you diversification. Unit investment trusts (UITs) are a fixed portfolio of securities usually with a 12 to 24 month term, therefore, no annual expenses only an upfront commission. Additionally, exchange-traded funds (ETFs) offer diversification and liquidity with lesser fees relative to mutual funds.
The bottom line is that mutual funds are not always the safe haven that they have been touted. The companies that manage mutual funds face a fundamental conflict between producing profits for their owners and generating superior returns for their investors. The best way to evaluate a fund is by digging a bit deeper into the fees and also looking at the turnover ratio prior to investing. It is important to understand the good and bad points. The probability of a successful portfolio increases dramatically when you do your homework. (For more, see: Mutual Funds: The Costs.)