The Mutual Fund Scam

Many financial planners sing about the virtues of mutual funds. They will tell you mutual funds are great long-term investments with high returns and very low risk. In reality, the only thing mutual funds are good for is lining the pockets of people who sell and run them. Before you invest in a mutual fund, consider the following.

There Are More Mutual Funds Than Stocks

At last count, there were over 17,000 mutual funds in the US. That’s more than all the stocks listed on the US exchanges. Do you see anything wrong with this picture?

Crazy High Fees

Mutual funds carry very high fees compared to other investments. You have purchase fee, redemption fee, exchange fee, account fee, management fee, fee for going to restroom, etc. Just buying a mutual fund puts you in the red from the get-go. The SEC does not limit the size of sales load a fund may charge, but the NASD does not permit mutual fund sales loads to exceed 8.5%. That is a crazy high commission. It means your mutual fund needs to increase in value by 8.5% just so you can break even!

Ah, but what about the backend loaded funds? They can be even worst. Sure, all your money goes into the fund but now you’re locked in for up to 10 years if you wish to avoid paying a load. If you need the cash before then, you have to pay a commission on not only the amount you invested but also on the gain as well! What about “no load” funds? There is no such thing. All funds have a load on it. The financial planner will get his commission for selling you the fund. If you do not pay the commission, then the fund pays it. Guess where the fund eventually takes the money from?

You Are Last In Line

Even before the fund makes one dollar, money comes off the top to pay the fund management company. It doesn’t matter if the fund makes or loses money, the fund company gets a percentage of the fund’s net asset value. Some funds have very high management fees – up to 2% of the fund value. That’s another 2% you have to make up to get back to square one.

Then we have the fund manager. This hot shot is supposed to turn your life savings into a fortune. For the work they do, mutual fund managers are among the most overpaid people in the world. Everyone on Wall Street makes far too much for moving money around, but mutual fund managers are the most reprehensible. Fund managers earn $500,000 to over $1 million a year including bonuses – but 70% of them can’t beat the market. In other words, you are paying them for a 70% chance of losing money. Oh, they will spin any profit as a gain but the question remains, if you cannot even match the market, are you making any real gains?

After the fund company and fund managers get their money, anything left over is yours. However, watch out for the redemption fee. You pay going in, you keep paying while you are in and you pay coming out. Someone is getting rich from mutual funds, and it’s not you.

It Is Possible To Make A Loss and Still Pay Capital Gains Tax

During a crash or market correction, the mutual fund value will drop. This drop can panic many investors, who will then pull their cash out (fees and backend loads be damned). If the fund is fully invested, the fund manager will have to sell some of the holdings in order to pay off the people redeeming fund units. While a normal investor would sell their losers and keep the winners in a down market, the reverse happens in a mutual fund. The fund manger will sell off the winners to pay off the people cashing in their fund so he can look good at bonus time – fund managers don’t get big bonuses for selling holdings at a loss. While this is good for the fund manager, it triggers a capital gain to you. So you are paying capital gains tax on a fund that is declining in value! Talk about getting double screwed!

Still Want To Invest?

If you still want to invest in mutual funds then do yourself a favor and stick to the low cost index funds. Index funds are like mutual funds except the fund manager doesn’t decide what to invest in, the index the fund covers does. For example, an S&P 500 index fund would only hold shares in companies that make up the S&P 500. If S&P drops a company from their index and adds a new one, the index fund must sell the dropped shares and buy shares of the newly added company. This is one reason why Google had to do a 2nd $4 billion offering. They got included in the S&P 500 and the index funds needed to buy their shares in order to maintain their proper holdings. The fees and expense ratio on an index fund are lower and their fund manager isn’t paid as much as a mutual fund manager – any idiot can manage an index fund.

Another alternative is Exchange-Trade Fund (ETF). ETF is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange, thus experiencing price changes throughout the day as it is bought and sold. Because it trades like a stock whose price fluctuates daily, an ETF does not have its net asset value calculated every day like a mutual fund does.

By owning an ETF, you get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share. The expense ratios for most ETFs are lower than those of the average mutual fund. One of the most widely known ETFs is called the SPDR (Spider), which tracks the S&P 500 index and trades under the symbol SPY.

Like any investment, the key is research. There are some good funds out there – 30% do manage to beat the market.


31 thoughts on “The Mutual Fund Scam”

  1. Jan says:

    It’s all comes down to the performance….

    hedge funds charge outrageous fees, some 50% of profits…..but some of their returns are staggering.

    I don’t mind paying high fees if I’m getting nice returns. However, what people should so is research the stuff and not buy funds that their bank/advisor pushes on them….financial advisors in general are a scam, people should learn the stuff themselves.

    globefund.com is great for research for mf’s.

  2. Derrich says:

    Not all mutual funds charge “go to the bathroom” fees, John. The mutual fund to which you’re referring sucks. (Whoa! I think that was proper grammar.) This is a scary article for sure. I’m glad you wrote that last sentence, because I became enraged by the first few paragraphs. I’m all better now. =)

  3. Derrich says:

    And I agree with Jan 100%. Do your research and don’t be a sucka. There are good ones out there.

  4. Rob says:

    I am a new financial advisor, I am NOT licenced to sell Mutual Funds, but I can sell similar products sold by insurance companies known as Segregated Funds or Seg Funds for short.

    Part of your argument is valid and part is flawed, management fees suck, there is no two ways around it. BUT you are paying for a service. depending on your advisor this service can be worthwhile or a rip off. A good advisor will not only help choose funds, but help organize your financial future as a whole, incuding taxes, estate planning, life insurance etc. Many advisors are now charging a set fee rather then a percentage.

    Indexes are safe but seldome offer the potential returns of a properly selected fund.

    funds exist becuase most people do not have the time, experience, or ability to buy a portfolio worth of individual stock and manage it properly. It is a full time job to do so and as such the management fees are used to pay someone to do this job.

    it takes money to make money

  5. erichb1 says:

    Try proof reading the stories you have other people write for you for you blog. How can you have misspellings in an age with spell checkers. What a idiot.

  6. H. Chan says:

    Actually if they charge the maximum 8.5% fee, you actually have to gain more than 8.5% to break even.

    Example from my text:

    1000 invested
    85 goes to the managers
    915 is actually invested
    85/915=9.3%

    You need 9.3% to break even.

  7. Brett says:

    I was a financial advisor for two years and this “article” is full of inaccuracies. The fees you talk about are ridiculous. Shop around.

    Fees? Um, there are many that have no annual account fee. There are many with very reasonable management fees….um, that’s kind of what you’re paying for. You want someone to buy and trade for you daily in large amounts for the entire pool of shares of all people invested.

    You’re basically paying someone to day-trade for you, plus you get instant diversification since a large fund holds many company stocks. Buy a handful of funds and you’re entirely diversified.

    There is no free lunch.

    Do you want people to buy/sell/trade for you for nothing? Is your financial advisor free? Is your lawyer free? How about any service you pay for? Would you like Class A, B, C, Y shares? It’s all just different ways of paying for the same thing.

    The shares I sold were typically A shares & had a 5.75% commission, but you should stick to buying funds in the SAME FUND FAMILY to get a reduced sales-load once you hit a breakpoint.

    For example: Once you’ve invested $50K you might get a reduced charge of 5%. Hit 100K and it drops to 4.5%. Usually anything over $1M was 0% commission.

    The financial industry is highly competitive. What other industry do you know that only makes 5% from you? Yes, they might make you 7-10%/year, but that fee is worth it. How else do you want to invest? Buying individual stocks? I know Edward Jones charges $52.95/buy/sell/trade. I believe that is higher now. I did not work for them, but know their sales loads. Sure you can do it on the internet for $5-20, but either way, you’re paying for a service.

  8. Kaka says:

    The theme of this article is so old

    http://finance.yahoo.com/columnist/article/richricher/6720

    Begin with a sensational headline, pour vitrol on the subject and add any good point at the end as an after thought.

    I have been investing in mutual funds over the last 20 years without any regrets.

  9. Marc says:

    The theme of John’s article may be a bit old, but it’s relevent and informative especially to new investors. Fund managers are as useful as door to door insurance salesman. I view traditional funds like an outdated computer. They’re still around and lots of people who don’t know any better will buy them, but they are legacy investment vehicles destined for the scrap heap. If you are an individual investor looking for low risk equity investments, then all you need are spiders and ETFs. If you’re looking for bonds and bills, buy them direct from the government over the net or through the mail. Fifteen minutes of online research will teach you a lot. Why pay some chump, for doing what takes anyone with a brain 15 minutes of research?

  10. Sonia says:

    John,

    This is an interesting article. There are two questions on mutual funds investments I had in mind.

    Are there any no load mutual funds that track S&P index or similar and do not fall under RRSP 30% foreign content limit?

    I understand that segregated funds compete with life insurance products. Can anyone expand on seg funds benefits?

  11. Eli says:

    Most mutual funds are bad investments, but the best will consistently beat the indexes, even after all the fees are paid. You have to shop around and find funds with low expense ratios that consistently beat the market. They are out there.

  12. Jan says:

    Sonia: There is no foreign limit in RRSP’s anymore.

  13. Carl says:

    erichb1 that is the greatest rant in the history of blog comment trolling. You bitch about John’s spelling, and finish with “what a idiot”

    That was just too great 😀

  14. e.p. says:

    This is the third financial post you’ve done with FUD or misinformation. Three strikes and you are out.

    I have straight mutual funds with two different companies. I don’t pay anywhere near 5%. Fund managers make a lot of money because they make me – and a lot of other people – a lot of money. Way more than a bond, a bank, or an index fund. Way more than trading individual stocks.

    My mutual funds have always beat the market over the long haul. Maybe I’m just lucky … the trick is you can pick your allocations based on how you invest. If you choose to be a wimpy investor (or if you are older and need a stable investment) then invest conservatively. If you are young (like me) and are investing for the long haul then what you want is an “aggressive allocation.” You will have negative quarters but you will have very positive quarters as well. Just my 2 cents worth as an active investor.

    oh yea, and it looks like you pretty much copied
    http://www.fool.com/school/basics/basics04.htm
    *sigh*

  15. John Chow says:

    e.p. – Fund managers make people a lot of money? You better check your stats on that. While you may have gotten one of the good funds that can beat the market, most of them can’t.

    As for a mutual fund returning way more than an individual stock, well, I just don’t know what to say to that. Which fund beat out Google’s IPO performance? Even if the fund held Google, they wouldn’t get the same return because a bunch of other stocks in the fund will pull it down.

    So you’re doing an aggressive allocation because you’re young? Sounds good. However, when you’re young, you really don’t need to be aggressive because time is on your side. It’s older people who don’t have a nest egg saved up who needs to be aggressive.

  16. Grant says:

    I read your article about 15 minutes after seeing this one on NPR

    http://tinyurl.com/z4puz

    In it Yale’s money manager describes how to make a balanced portfolio and does some light mutual fund bashing.

  17. brainscan says:

    The post claims that 30% of mutual funds beat the market. Later comments, by Rob, Eli, and e.p say that investing in actively traded mutual funds works if you know how to pick them. Both of these statements are wrong.

    First, while 30% of mutual funds may beat their respective market index this year, the same funds won’t beat their averages next year, and almost definitely will not beat for 10 years straight. I’ll give $1 million to anyone who can give me a list of the 30% of mutual funds that have beat the market every year for the past ten years. (I don’t have $1mil yet, but you don’t have that list, so we’re even)

    Second, it might be possible to find a list of several mutual funds that have beat the S&P500 each year of the past ten years, but it’s very unlikely that those funds have beat their respective index. For example, over the past five years, small cap stocks and emerging market stocks have done really well in comparison to the S&P500. Maybe Rob, Eli, and e.p have really made a killing!!! But they probably would have done better with a S&P400 small cap index fund and a MSCI EAFE index fund.

    An aside, listen to the NPR story about the Yale endowment manager (http://www.npr.org/templates/story/story.php?storyId=6203264) and read Jeremy Siegel’s book “The Future for Investors”.

  18. John says:

    Open your eyes, people. Fund managers rarely beat an index. And, if a manager does beat an index, it is even more of a rarity for that manager to repeat that performance. The theme of this article is relevant and important. Anyone that pays a fund manager is only paying someone to gamble with their money.

    http://www.ifa.com/12steps/step5/step5page2.asp

    I suggest reading the entire guide, btw.

  19. William says:

    Interestingly and not a little bit ironicly, this article is filled with enough incorrect statements of fact that, had its author been a registered person, he would find himself struggling to avoid disciplinary problems.

  20. HMTKSteve says:

    My main problem with Mutual Funds is that you are giving your money to someone else to buy stocks with.

    If those stocks have “voting rights” then an unscrupulous fund manager can use them to buy stock in a company near voting time to get votes and then sell them afterwards.

    With the large amounts of cash involved in Mutual Funds it is relatively easy to do this.

    This is the same argument against the government getting into the stock market. when you deal with transactions of such magnitude the simple buying and selling of mass quantities of shares in a company can cause a false bubble.

    Just look at the spike and rapid fall of oil prices. How much of that was real and how much was uninformed investers trying to jump on a trend?

  21. LuLu says:

    I was a Financial Advisor from a Broker Group. As an advisor, I would suggest my clients to invest in the products which best fit their financial situation and the level of risk tolerance which they are capable to take. Everyone is different, so there’s nothing in the market should call the best products that can gain you money or save you tax!!!

    Again, there’s nothing called Free Lunch in this world. You pay for every service you wish to get and you also pay for all the risk which you’re willing to take.

    Lots of ppls would like to invest their money in stocks. It might works for those who are still young so even they lose, they still have time to recover and also for those who can take the risk on the up-and-down market, playing short-term so they can learn the lesson and gain more knowledge on the stock market and come back again and again… These ppls got a lot of satisfaction when they have a good performance on their portfolios. But they’d have to be very knowledgeable or should say “Lucky” in order to keep a good record. Think about the pool of money in the investment market, 80% are managed by Funds mgrs and only 20% are for individual investors. What are the chances to guarantee the rate of return? Do you really want to risk your hard working money into the 20% sector? Do you know the tax you have to pay when you sell your investment?

    For those that would rather invest their money into the 80% sector, but feel ripe-off on the MER. Well, this group should better save their money in the Bank, earning approx 3% interest rate and paying 100% tax with an inflation of 3.5% or higher. They shouldn’t invest at all.

    But if you think you can accept paying service so someone who can manage your investment then you should know about the difference MER charges between Mutual Funds and Seg Funds.

    Again, you are asking for difference Protections on the investment so you’re paying difference Service Charge (MER). Simply Seg Funds have approx 1.5-2.0% higher than the same sector of Mutual Funds. Hahaaa… some ppls may even feel worst when they heard about it… Well. If I tell you what types of Protections that Seg Funds can offer compare to Mutual Funds, then you might think it is worthy to pay the higher MER.

    Other than the same benefits you have in Mutual Funds, Seg Funds also provide the followings:

    – Creditor Protection (in case of bankrupt, your creditor cannot touch this)
    – 100% Death Benefit guarantee (Even the market drop and you die, your beneficiary get 100% of your original investment.
    – 75%-100% Maturity guarantee (If you hold the funds up to the Maturity date, it’ll protect you against market fluctuations)
    – Bypass Probate court (it means when you die, these chunk of investment will rolled over to your beneficiary Tax free, just like an insurance)
    – Reset of Principle (You can lock up the amount when the market is going up, then the guarantee will be reset to the new amount. But the maturity date of your account will start again and it’s depends on the products you got)
    – Switch among funds and fund managers within each fund family,
    Fee-Free up to 5 times per year.

    Personally, I think that the extra 1.5-2.0% MER which I’m paying compare to Mutual Funds. It is much worth it with all the aboved protections and benefit. Again, these might fit for certain type of Investors. And especially for those that cares about how to protect their money even the market went down and how to pass the investment money to their Estate without suffering from the Taxation payment.

    I think I’m typing an essay. And for those who’d like to know more on this, please email me at [email protected]

    Cheers;
    Lulu

  22. I think it’s very encouraging that someone who writes articles with basically no content that are usually either totally wrong or extremely obvious can gain such a following. Imagine what kind of cash I could make if I wrote articles that weren’t steaming piles of…well you get the idea. You obviously lost some money on a mutual fund recently and are a little bitter. I happen to have paid for my college with one, so maybe I’m biased. This misinformation filled article is even worse than the plain old worthless ones like the one about not working an hourly job. Wow, you mean if I have a job where I get paid by the hour I’m never going to escape the constant relationship between time put in and money that comes out? That’s brilliant, it’s almost like they would have taught these concepts in grade school…oh wait they did. It’s obvious to me now that Digg.com has been contaminated by idiots who find misinformation and the the glaringly obvious highly informative. I’ll be marking your articles on Digg as inaccurate from now on. Don’t worry though, I’ll probably stop using Digg soon as there are much better alternatives out there.

  23. John Chow says:

    Very Encouraging – I haven’t lost any money on mutual funds because I don’t invest in them. Mutual funds are for average investors looking for average returns.

    So you made some money with mutual funds and it paid for your college. Great! Now think of how much more money you could have made if you were smart.

    Enjoy your job.

  24. einstein says:

    Not all smart people care to make a lot of money. Some are simply satisfied with average returns (and less wrinkles from sleepless nights). Furthermore, hustlers also may end up shooting themselves in their 50K+ cars (Enron). Most things in life have a “load”. Some “load” is tangible, as is the cost of college and some “load” is not.

  25. einstein says:

    Money always shifts from stock to stock; from sector to sector; from region to region; etc (cyclicity). People tend to buy whatever’s hot and hope to get out before it cools off (naturally). The money shift tends to be slower for segments, sectors and regions than it is for individual stocks (liquidity). Therefore, do your research; pick some low cost ETFs (check fees and rules) and follow the big cash or (if not challenging enough) try to beat it.

  26. LuLu says:

    Really not surprising at all to know there’s ppls like “Very Encouraging” existed in this world. Lots of people think they know everything and doing the right thing and never willing to find out more. It happens to my clients too. “Very Encouraging”… Hmmh… such an ironic name. It’s okay. Life is easy and short. People do enjoy the way they choose, so I hope you’ll enjoy you job too.

    Cheers;
    Lulu

  27. ryoma says:

    Some of my friends work as fund managers and stock brokers. The one thing I can tell you is they are, by any definition, dishonest profession. It’s just the way the industry practice is. You don’t have to believe it and I don’t really care if you want to remain a sucker.

    Both fund managers and stock brokers front run their customer whenever they have the chance. Fund managers cut all kinds of deals with outside scam artists to jack up the price of the stocks they already own. The concept is like this, they are given a discounted price to buy a considerable amount of ABC stock, or given a certain amount of ABC stocks. Their side of the deal are to buy ABC stocks in the market with the funds under management. This money made from this kind of deals are way more than their salaries.

    The concept of mutual fund is like betting on both big and small in a casino table. And they charge you commission fee for placing a bet, lol. Your money will in theory decrease. However, due to the expansion of the money supply, your investment in number term will invariably (unless you have really bad luck) increase. But I doubt very much if your buying power will increase in the long run.

    If you can tell that the market is exactly the same as the casino, you have finally put all you learn together.

  28. Peter Drang says:

    The entire mutual fund industry, with the possible exception of a few index funds, is a scam.

    Even ones that appear to have great performance are a scam. The game they play is, the fund company starts, say, 20 funds. A few years later most have underperformed the market but a few have (randomly) outperformed. They then kill off all the funds that underperform leaving only the few that randomly outperformed the market for several years in a row.

    Then if you look at their results they appear to have nothing but winners. In fact they are only showing you the winners, the losers are long gone.

    You might say, “well if the fund outperformed several years in a row then it will probably keep outpeforming because the managers are better.” But academic studies have proven that even a fund that outperforms, say, 4 years in a row is no more likely to outperform the market the following year. And the amount of experience the managers have also bears no relationship to whether it will perform well. The fact is, over several years time horizon almost all funds underperform, and if you look over long enough horizons the vast majority (99%) underperform, and there is no way to figure out which ones are the 1% that will keep outperforming because it’s basically random.

    In addition, over long periods of time the fees eat up most of the market growth. Do the math and figure out how much $1000 is worth in 30 years, first at a 11.5% growth rate, then at a 10% growth rate. Pretty shocking how that 1.5% fee adds up. And because studies have overwhelmingly shown that there is absolutely no benefit for the “management” you are buying with those fees, that’s money that is totally wasted.

    All mutual funds are scams except a few index funds that have ultra-low fees, but even with those you’re better off trading ETFs. Just buy SPY or MDY EFTs if you want large or midcap. For bonds just buy some treasuries yourself, you can buy direct using Treasury direct for zero fees, or buy through your broker for a little extra convenience. Never, ever, buy a mutual fund.

  29. Kenric says:

    I used to invest in many funds scattered about many different companies. I finally settled on just the S&P500 index fund. Although now I only a have a few stocks and mainly do real estate.

Comments are closed.