September 4, 2008

Five Reasons Why Mutual Funds Suck

American households are the largest group of investors in mutual funds. However, mutual funds have shown that they are not the best place to park your money. Below are five reasons why mutual funds suck:

They Don't Perform Well

According to this article written in August 2008, "Out of almost 2,100 diversified retail U.S. stock mutual funds that are open to new investors, just 17 have positive returns for both the past 12 months and year-to-date."

To be fair, the S&P 500 is down approximately 13% between August 2008 and August 2007. But, how many mutual funds are down more than that amount? Quite a few.

Even in prosperous times, mutual funds haven't shown to outperform the market. In 2005, the average US diversified equity fund grew 6.7 percent, the third upside year in a row, according to fund-tracker Lipper Inc. Yes, 6.7% is growth. Yes that is better return than a CD or a savings bond, but 6.7& is hardly anything to get excited about.

High Fees

According to a study published by Standard and Poor's,
U.S. mutual fund companies collect $12 billion per year in fees for their funds. And some $442 million of this comes at funds that are closed to new investors — charges that are assessed even though the funds no longer need to cover marketing and distribution costs to attract and begin serving new customers.

Mutual funds have a fee to purchase, maintain, and leave the fund. Is there a limit on the fee amount that you can be charged? Sure. The National Association of Securities Dealers does not permit mutual fund sales loads to exceed 8.5%

What about no load funds? The fees won't be as high, but you will be the last to benefit from any paltry gain that the fund makes. The fund management company is entitled to a percentage of the gain first (up to 2% of the fund's value), in addition to the fund manager's commission.

So, it is possible that your mutual fund may need to earn more than 10.5% before you actually begin to earn any return on your investment.

Restrictions

Have a bad mutual fund? Want to get out? You will have to wait until the market closes. Since mutual funds are priced at the end of each day that the market is open, they can only be bought and sold when the market is closed. So, if a stock in the mutual fund tanks (or the entire fund for that matter), you can't get out until the market has had all day to beat it to death.


Mutual funds are also restricted on how much of a security they are allowed to buy. So, if a stock in the fund goes through the roof because a company invented a time travel device, the mutual fund will not be able to fully capitalize. Even if the fund did hold shares, those shares cannot comprise more than 20% of the fund's assets.

You Pay Taxes on Bad Trades

If a fund is underperforming, and investors begin to cash out, a fund manager may sell stocks in the fund that have made a gain in order come up with enough cash for the payout. Why don't they sell the underperforming stocks? They don't get a bonus for selling the underperformers. Regardless, you pay the capital gains tax on the winners that they did sell.

You also pay taxes on when the fund bought the stock, not when you bought the mutual fund. Say the mututal fund bought shares of Yucky Foods Inc, (YUCK) at $10.00 a share in 2005. You then bought into shares of the mutual fund in 2007 when YUCK was trading at $20.00 a share. In 2008, the fund manager sold shares of YUCK at $15.00 a share. You then pay a capital gains tax, since the fund realized a gain of $5.00. The fund doesn't care that you personally took a $5.00 loss on that trade.


Bad Fund Managers

Just like mechanics, doctors, and teachers, there are good and bad fund managers. Just because someone is a "professional" doesn't mean that they are guaranteed to do a good job managing your money, especially since they are going to get their cut first. In fact, the number of active fund managers that can beat the market are rapidly shrinking.

What to Do?

If you would like to stick to trading funds, you can try Electronic Trading Funds (ETFs). They are similar to traditional mutual funds, but they trade like stocks. They can be bought and sold throughout the day, and they typically charge lower fees too.

However, with a little research, you can invest in individual stocks yourself. You eliminate the high overhead of mainting a fund and can reap the benefits of finding great stocks that can offer market beating returns for years to come.


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