Why Do Some Investors Dislike Mutual Funds?

Every now and then, I talk to a potential client who asks why we use mutual funds. The tone of the question is usually derogative, as if there is something inherently wrong with the mutual fund structure. I get the impression these individuals feel they deserve something “better” than mutual funds. Since our portfolios are comprised of mostly mutual funds and ETFs, naturally I wanted to know why these feelings about mutual funds persist. Here are some of the objections I found.

Mutual funds charge high fees. This objection to mutual funds is partially true, but industry-wide, fees are trending lower. The average stock fund expense ratio fell from 0.99% to 0.74% between 2000-2013. Similarly, the average bond fund expense ratio fell from 0.76% to 0.61% during same time period.[1] However, mutual fund expenses of 1.50% – 2.00% are not uncommon, and high fees do reduce investor returns, sometimes significantly. At the heart of the fee argument is the notion that an investor can buy the individual stocks themselves, without paying an ongoing management fee. “Why should I pay a fee, when I can do it myself?” The Do-it-yourself mentality is pervasive in investing. Vanguard Group estimates that 25% of all investors prefer to do it themselves.

Response: Appropriately priced mutual funds are an excellent vehicle for a group of investors to share in the cost of investing in a large number of stocks, bonds, or alternative investments. There are low priced mutual funds available in every segment of the market. Avoid paying sales-loads, and instead look for no-load or institutional share classes of mutual funds. Refer to the average expense ratios mentioned above and search for funds with less than average expenses. Remember though that price is not the only factor in selecting a fund. Funds in certain parts of the market such as small cap international stocks, commodities, or managed futures have higher expense ratios because there are higher costs involved in investing in these markets. Focus instead on the weighted average expense ratio of your portfolio as a whole.

Mutual fund managers don’t beat their benchmarks. There is also some truth in this argument against mutual funds. Over a 10-year period ending December 31, 2013, only 19% of stock mutual funds outperformed their stated benchmark. A look at the data also shows that recent outperformers generally slide into the bottom of their categories in subsequent periods.[2] In other words, strong track records fail to persist. Based on these numbers, an investor has an 80% chance of underperforming the benchmark when investing in a mutual fund. Underperformance adds another layer of potential worry for investors. Instead of simply picking the right stocks, the investor now has to pick the right fund manager. There’s also a loss of control element to turning the individual security selection over to a mutual fund manager.

Response: The statistics on funds failing to beat their benchmarks are grim, but investors are changing the conversation. What if the goal of investing isn’t to beat the benchmark, but rather to earn the benchmark return? To use a golf analogy, par is a good score. Investors are now using low-cost, passive, index-based strategies to capture the return of the market rather than paying higher expenses to try to beat it. Consider using passive strategies as the core, to capture major segments of the market return. Active managers have better track records in US small cap stocks, international small cap stocks, and global bonds. Perhaps these are the areas to try and beat the benchmark.

Mutual funds are tax inefficient. Mutual fund investors share the dividends and capital gains realized inside the fund. When investors pull money out of the fund, the fund manager may need to sell stocks at a higher price than the purchase price, realizing capital gains. Mutual funds must distribute these capital gains to fund holders by year-end. If the fund experiences large inflows or outflows, the capital gain effect can be magnified. Investors owe tax on distributed gains, which can sometimes be substantial. The argument against mutual funds is that the investor has more control over realized capital gains by owning stocks individually.

Response: Not all mutual funds are created equal. Funds with lower turnover, a measurement of the percentage of a fund’s holdings that have been replaced (turned over) during a period of time, generally distribute fewer capital gains. Investors can also avoid capital gains by avoiding “hot money” mutual funds. These are the funds experiencing large inflows after reporting great performance numbers. Often these funds subsequently underperform, causing the hot money investors to flee the fund, which in turn forces the fund to sell securities and realize gains. There are other tax strategies too lengthy to discuss in this article. Bottom line – there are tax efficient ways to invest in mutual funds.

Wealthy individuals perceive they can do better. Mutual funds rose to prominence in the late 1980’s. Prior to that time, investing in the stock market meant buying individual stocks. Most Americans were unable to afford individual stocks and the commissions charged by sales brokers. At that time, only wealthy individuals invested in the stock market. With $100, a small investor could hardly buy a few shares of one company. Once mutual funds were widely available, $100 could buy a diversified portfolio of stocks. Over the next decade, average Americans invested in the stock market en masse through mutual funds. Perhaps wealthy individuals began to perceive investment in individuals stocks as “better” than mutual fund vehicles used by smaller investors. Thirty years later, this lingering perception remains.

Response: This objection lies deep in the psyche, so plan on some major self-reflection. Strip away the financial terms and lingo associated with investing, and the goal is simple – to preserve and maximize wealth. If mutual funds are the right vehicle to achieve this goal, then it shouldn’t matter that they are widely used. It’s time to strip this stigma from mutual funds entirely.

Mutual funds water down returns with too much diversification. This is a less common objection but one I found interesting. By owning hundreds, or even thousands, of stocks inside a mutual fund, a huge move in one stock is muted. No individual stock will significantly affect the portfolio.

Response: Diversification is the strongest tool investors have to mitigate the ups and downs of the markets. Investors who enjoy betting on single stocks can always set up a “play” money account with a small portion of their overall wealth.

Mutual funds are the pooled assets of many investors looking to buy a particular market segment, strategy, or asset class. They are essentially no different than owning stocks or bonds individually, except that most (like 99% of them!) investors can own more securities through mutual funds than they could individually. While it is true that there are funds with high fees and that many funds fail at beating their benchmarks, this should not cause investors to paint all mutual funds with the same brush. Mutual funds allow investors to access market segments that are cost prohibitive to invest in directly; such as, international stocks, emerging market stocks, international bonds, commodities, and other alternative strategies.

The days of investing in a basket of individual, large cap US stocks and a few bonds have passed. This is an antiquated method of investing that ignores the global nature of today’s markets. Investors still choosing this path are missing major portions of the world’s investable markets, losing potential returns and diversification benefits. Mutual funds are one of the tools that assist investors in accessing a broader scope of the market and creating globally diversified portfolios. To write all mutual funds off as “average” is a mistake.

 

– Blair duQuesnay, CFA, CFP(R)

 

[1] 2014 Investment Company Fact Book; 54th Edition, by Investment Company Institute, www.icifactbook.org

[2] Dimensional Fund Advisors, The Mutual Fund Landscape – 2014 Report.