Although mutual funds are one of the most popular investment instruments, there are a number of "secrets" about mutual fund investing many investors do not know.

Investing in the Top-Performing Funds Does Not Usually Work

One common investing strategy used by many mutual fund investors is to look through the fund rankings at the end of each year and pick the top four or five best-performing funds to invest in for the next year. On the surface, this sounds like a reasonably logical investment strategy. There is just one problem; it does not usually work very well. The strategy overlooks the fact that investments tend to be cyclical. For example, what is up one year is often down the next, and the odds are strongly against the fund managers of actively managed funds being able to substantially outperform the overall market on a consistent, ongoing basis.

According to a recent Standard & Poor's study, fewer than 10% of the best-performing funds in 2012 were even in the top 25% of funds by 2014. To put it another way, if you invested in the best-performing 2012 funds at the beginning of 2013, there was more than a 90% probability that by the end of 2013, those funds were underperforming. And according to the study, the odds only get worse over time. The study found that after five years, fewer than 1% of the previous top performers were still in the top 25% of mutual fund rankings.

Fund Fees Take More Money Than You Think

Many mutual fund investors fail to understand the importance of expense ratios and other fund fees in regard to how much they affect potential profitability. A lot of investors see a 1% expense ratio figure and immediately dismiss it as inconsequential. This is because they have the mistaken idea that the 1% fee is only taken out of whatever profits they make. But this is not the way it works. The fee is applied not to profits, but to an investor's total investment capital, which means it takes a much bigger chunk of an investor's profits than many investors realize. For example, if an investor has $10,000 invested in a mutual fund with a 1% expense ratio, then the annual fee represents $100. Suppose the fund makes a respectable 5% profit for the year, returning $500 to the investor. That 1% fee, because it is 1% of the $10,000 investment rather than just 1% of the $500 profit, does not reduce the investor's profits by just 1%, as many investors mistakenly believe, but by a whopping 20%. If the fund performs even lower, generating only a 2% profit for the year, the 1% fee takes half of the investor's profits.

A Lot of Actively Managed Funds Are Just Index Funds in Disguise

According to Motley Fool analyst Dan Dzombak, recent studies reveal that a number of actively managed mutual funds are in reality "closet" index funds disguised as actively managed. Dzombak refers to two studies conducted in 2009 and 2013 that examined 20 years' worth of mutual fund data. Both studies found that during that 20-year time span there was a huge increase in closet index funds, from approximately 10% of funds to almost 30% of all mutual funds. In fact, the fund manager's "active" stock selections pretty much just mirror the selections of a benchmark index, and the fund's portfolio does not differ substantially from index funds. It is easy to see how this can happen. Fund managers are concerned about maintaining a perception of good performance. One way to go about that is to ensure the fund's performance is not too far off the average performance of popular stock indexes.

Since the fees for actively managed funds can run as much as 10 to 20 times higher than the fees for an index fund, investors need to take care to ensure they are actually getting the active management services for which they are paying.

ETFs Might be a Better Investment

One thing mutual fund managers often fail to disclose to mutual fund investors is because of the different way in which exchange-traded funds, or ETFs, are structured as compared to mutual funds, ETFs are often an overall better investment. One of the advantages of ETFs over mutual funds is greater liquidity. Unlike mutual fund shares that can only be bought or sold at their end-of-day net asset value, or NAV, price, ETF shares are freely traded throughout the day on major exchanges. Another advantage, again simply due to the different ways in which ETFs and mutual funds are constructed, is the fact ETFs usually create many fewer taxable capital gains events for investors.

For example, if a large number of mutual fund shares are redeemed at the same time, the fund manager often has to liquidate part of the fund's holdings to pay for the redeemed shares. This usually results in some level of taxable capital gains for fund investors. Since ETF shares are sold to other ETF investors through an exchange, that kind of taxable event does not happen. One of the little-known secrets about mutual fund investing is even a mutual fund investor who never sells any of his shares can still be subject to substantial tax liabilities. Additionally, the expense ratio for ETFs is typically lower than the expense ratio for a comparable mutual fund, sometimes by as much as 50%.

Mutual Funds Can Provide a More Efficient Means of Investing

One good "secret" about mutual funds is they offer an easy, efficient way to invest in the equity market due to the fact mutual funds allow for the purchase of partial shares. For an investor with a personal financial plan such as contributing a flat amount of $100 a month to investing, this simplifies the process of following his plan and can make for considerably more efficient investing. If the investor attempts to purchase individual stock shares selling for $60 per share, he has to set aside nearly half of his intended $100 monthly investment, $40, until the following month when his next contribution provides sufficient capital to purchase an additional share. Not only does that delay his investment, but it could easily cost him money if during the intervening month the stock price rose from $60 per share to $70 per share. Mutual funds overcome this problem by allowing investors to purchase partial shares, so the investor in this example could invest all of his $100 monthly investment contribution without problem or delay.

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