Investments, such as stocks and bonds, can be incredible, wealth building assets. Investors who choose the correct securities and products can expect to benefit handsomely over time. On the other hand, investors who select bad investments are not likely to achieve their financial goals—due to poor returns. They might also lose their investments. To choose good investments and become an intelligent investor is easy. The first step is to improve your financial literacy by reading top rated books like A Random Walk Down Wall Street, The Intelligent Investor, and The Little Book of Common Sense Investing. These books will shorten your learning curve and improve your financial wisdom. The second step to becoming a smarter investor is to understand your investments.
As an investor, you have many decisions to make including whether to invest in individual securities, funds, or both. Most investors probably lack the time and dedication required to research and track individual stocks making investment funds an excellent alternative. Mutual funds allow investors to purchase a group of securities with ease. They’re a convenient alternative to buying individual securities. For example, the Vanguard 500 Index Fund (VFIAX) is a low-cost way to gain diversified exposure to the U.S. equity market. The fund replicates the components of the S&P 500 index and holds stocks like Apple, Microsoft, Johnson and Johnson, and Bank of America. So, instead of buying large-cap stocks individually, an investor can buy the VFIAX for instant diversification.
Mutual funds are familiar with everyday investors and have been around for decades. Investors have also gravitated to exchange-traded funds (ETFs), which are like mutual funds but different. Exchange-traded funds began trading in Canada in the 1990s and have spread across the world like wildfire. Concerning ETF assets, Vanguard, BlackRock (iShares), and SSGA (SPDRs) have trillions under management.
I don’t invest in mutual funds because their ETF equivalents are usually much cheaper, and being able to keep more of my money is a distinct advantage. Investors pay, on average, 0.35% more for an index-tracking mutual fund than for an index-tracking ETF, based on the expense ratio. For example, Vanguard’s Total World Stock mutual fund has an expense ratio of 0.21% compared with its Total World Stock ETF at 0.11%. (Vanguard’s minimums to invest in their mutual funds also range in the thousands whereas ETFs don’t have minimums.) If you’re investing in higher cost mutual funds when similar ETFs are available, you’re doing yourself a disservice. That said, mutual funds by themselves aren’t bad investments. For example, mutual funds with low investment minimums might be beneficial for some investors. Mutual funds tend to be bad investments only when sold by mutual fund brokers or salespeople. Not all mutual fund brokers are competent, well-informed finance professionals, which could result in you getting terrible recommendations. Let’s look at how mutual funds might be decreasing your wealth prospects.
1. Actively Managed Funds Consistently Underperform
Two investment strategies engulf portfolio management; passive and active management. Passive management is where a fund’s portfolio mirrors a market index like the S&P 500 and NASDAQ 100 indices. Securities held in the index are held and weighted equally in the fund. Passive management is the opposite of active management in which a fund’s manager or managers attempt to beat the market with various investing techniques including fundamental and technical analyses. The portfolio manager determines the holdings and weightings of securities.
The idea of active management is fantastic, but very often comes up short against Mr. Market. For every Warren Buffett, Ray Dalio, and George Soros—legends of the investing world—you have tens of thousands of portfolio managers who underperform their benchmarks each year. Financial news media companies report fund manager performance from data contained in the SPIVA U.S. Scorecard from S&P Global. The heading of this CNBC article reads, “Bad times for active managers: Almost none have beaten the market over the past 15 years.” It reports that 66 percent of large-cap active managers failed to top the S&P 500 in 2016. Performance actually got worse over longer time frames, with more than 90 percent missing benchmarks over a 15-year period.” Also, 89.4 percent of mid-cap managers and 85.5 percent of small-cap managers fell short of benchmarks.
Millions of investors have caught onto the active management scam, which rewards portfolio managers by way of massive salaries and penalizes investors by way of bad returns. In fact, investors continue to transfer billions from active funds into passive funds. However, investors are still buying active mutual funds, usually through brokers, despite the empirical evidence for index investing. Brokers sell actively managed funds because they are designed to compensate them whereas passively managed investments are not. Also, brokers haven’t had to act in the best interest of their clients, which has only changed recently.
Investment fund companies, like Fidelity, create active mutual funds with different load or sales charge types such as front-end, back-end, and low-load. Brokers charge whichever model their clients prefer. Conversely, investment fund companies, like Vanguard, do not compensate advisors for selling their funds. Vanguard offers no-load funds since they want to keep investing costs low for investors. So, even if a broker felt index funds would be better for his clients, he was likely to recommend active funds to get compensated. For example, Edward Jones paid $75M to the SEC because they “failed to adequately disclose revenue sharing payments that it received from a select group of mutual fund families that Edward Jones recommended to its customers.”
Despite the apparent conflict of interest, regulators had traditionally held brokers to low standards of care in which they only needed to prove suitability regarding their recommendations. This differs from fiduciary standards of care, which puts clients’ interest first. It’s also important to note that mutual fund brokers aren’t likely to educate their clients about the benefits of ETFs since they’re licensed only to sell mutual funds.
Note: Former President of the United States, Barack Obama, introduced sweeping changes to investment advisory practices. Basically, he wanted to afford investors more protections by assigning fiduciary responsibilities to all types of investment advisors, including mutual fund brokers. The current president, Donald Trump, has sought to delay implementation of these rules. Some rules have been implemented while complete implementation has been pushed back to July 1, 2019. Once these new guidelines are fully implemented, investors can expect more suitable recommendations.
2. High Fees Are Synonymous with Active Mutual Funds
Active mutual funds typically carry higher fees or expense ratios because of the need to compensate portfolio managers and advisors. The average active fund charges 0.78% in annual fees compared with 0.18% charged by passive ones. That’s a difference of 0.60% or $600 on a portfolio of $100,000. Paying an extra $600 for a product that is likely to underperform doesn’t sound like a good deal to me. Keep in mind that 0.78% is the average, which means some funds charge a heck of a lot more. For example, 1 percent, 1.5 percent, or more. You might be thinking a slight uptick in fees is no big deal, but fees are what hurt investors. The chart below captures the sentiment correctly, and you can run different fee scenarios here.
3. Active Mutual Funds have Expensive Hidden Fees
The expense ratio of a mutual fund is revealing, but not as telling as it should be to assist investment decision making. Portfolio managers rack up trading fees, which are not reflected in expense ratios. These trading fees can get costly—an average of 1.44%—for active funds because, well, investment managers are actively trying and trading to beat the market. A fund’s trading fees are usually buried in its prospectus under “trading expense ratio” or TER. According to Kenneth Kim,
“First, mutual funds must pay brokerage commissions when they trade. This cost is shared by all mutual fund investors. Second, mutual funds will often purchase securities from dealers at ask prices and sell securities to dealers at bid prices. Ask prices are higher than bid prices. This bid-ask spread represents the dealer’s profits. Because mutual fund investors are commingled, the profits that go to dealers when mutual funds trade, in order to accommodate other investors entering or exiting the fund, imposes a cost onto the fund, which is shared by all investors. Third, when mutual funds trade, because their trades are often so large, their trades can cause securities’ prices to move. Their buying can push prices up, and their selling can push prices down. This phenomena is known as price impact, but because the price of the impacted securities tends to return to its previous price, price impact causes mutual funds – and you – to lose money.”
Capital Gain Tax
As portfolio managers buy and sell securities, they realize capital gains. Fund investors must pay taxes on these gains, even if they didn’t personally benefit. Also, an investor might be on the hook for capital gain taxes, even if the fund decreases in value. Tax inefficiency cost an average of 1.10%. In contrast, passive funds are more tax efficient because their portfolio managers follow buy and hold strategies to mirror the indices their replicating, which yields less asset turnover, buying, selling, and lower trading costs.
4. Delayed Information Impacts Decision Making
I like ETFs because I can obtain real-time prices since they trade on exchanges like stocks, and ETF details are updated daily. For instance, a fund’s holdings, weightings, performance, and so forth are refreshed each day. On the other hand, mutual fund details–active and passive–are typically updated monthly or quarterly. Also, mutual fund prices are calculated at the end of each day. Whether you’re a buy and hold investor or trader, information powers decision making. The information delays experienced with mutual funds make them an inferior product in an information and technology age.
Active Mutual Funds Are Not the Product of Choice
What’s more, I would have no problems recommending index mutual funds to people new to investing and investors with low investable assets, but I would encourage investing in ETFs sooner rather than later. My issue is with active mutual funds, which frequently underperform their passive counterparts and cost more. (I’m not a fan of actively managed exchange-traded funds either.) Also, active mutual funds tend to only benefit the investment companies, portfolio managers, and advisors who peddle them; not the investors who buy them. The alternatives to buying active funds are to switch to a robo-advisor or become a DIY investor with an understanding that passive investing, through mutual funds and ETFs, is the prudent approach.