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 â€œno loadâ€ 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 â€“ 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 â€“ 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 â€“ 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 â€“ 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.