Three Dangerous Pitfalls of Mutual Fund Investing
The first mutual fund was launched almost a hundred years ago, and since then, the industry has grown to over $20 trillion in assets under management. Mutual funds are appealing because they remove the single stock risk, combine multiple stocks into a product that costs less than paying for a portfolio manager to create an actively managed separate account. And this appeal comes at a cost that comes out of your pocket!
But are they still the best option for your portfolio? Or there are any alternatives? That is the real question today’s Investor needs to ask.
Owning a portfolio of several different mutual funds today may mean holding exposure to thousands of different stocks, but there are downsides and hidden costs to consider. Exchange-Traded Funds (ETFs) provide similar diversification benefits of the mutual funds, and now offer access to a broad spectrum of assets classes and styles, with much lower costs. And they are generally more tax efficient.
So, here you go: Here are the three reasons why you may consider a portfolio of Exchange-Traded Funds (ETFs) as opposed to a portfolio of mutual funds.
Mutual Funds Are Not Tax-Friendly
Mutual funds and ETFs are both subject to capital gains taxes. But ETFs have a clear advantage that derives from their structure, making it rare for an ETF to report a capital gain that is passed on to the investor. Mutual funds, in contrast, must constantly rebalance the fund as shareholders redeem assets. These sales create capital gains, which mutual funds must pass on to the investors at the end of the year. As a result, mutual funds regularly report capital gains, and investors will receive a 1099-DIV each year that must be accounted for in tax planning and reporting.
Mutual Funds Expenses Goes Way Beyond the Expense Ratio
Investors often select mutual funds because they offer broad exposure to the market for less than the cost of other options, such as the traditional separately managed account. But they are not as cost-effective as they may appear. There are hidden costs that must be considered because the total cost of the fund will impact the return the investor receives.
Whenever I bring up the cost of mutual funds, there is one cost many investors are aware of – the expense ratio. However, there are other hidden costs to consider – in addition to the expense ratio – such as transaction costs, sales fees, and how much of the portfolio will be held in cash. John Bogle, the creator of the first index fund, wrote a seminal white paper on the topic. He attempted to make reasonable estimates of all the above costs so that mutual fund investors would have a clear view of what they were paying.
Transaction Fees: This is simply what it costs to buy and sell securities. While one estimate put these as high as 1.44%, Bogle was more concerned with overstating them and went with a more conservative estimate of .50%.
Cash Drag: This refers to the impact on returns of not being fully invested. In other words, mutual funds usually hold approximately 5% of their assets under management in cash. The cash is not earning any return. Bogle estimated that the drag on the performance of this percentage of assets not being put to work was .15%
Sales Fees: This is the cost the investor pays to invest in the fund, as paid to a broker or investment advisor. Since some funds charge these fees and some don’t, Bogle settled on an overall cost of .50%, half the usual 1% charge here a fund imposes these fees.
Adding It Up: Based on the research, these hidden fees add up to 1.15%. That more than doubles the cost of a mutual fund with an expense ratio of 1%.
Selecting Consistently Performing Mutual Fund Managers is Difficult
The argument for mutual funds is that you are paying for the benefits of active management. The outperformance over the fund’s benchmark, which is usually a stock index, will make up for the cost through return. The returns will be greater than could be achieved by buying a passive strategy that replicates the index.
Does that really hold up? Well, for the top percentage of managers it can work. The problem is picking those managers, especially over time. A manager that has a good streak of performance may then experience trouble that is not market-related. What chances does the investor have of picking a manager that will consistently outperform?
Vanguard sought to answer this question and found that over a 15-year period of returns for all actively managed US domestic equity funds starting in 1998, only 18% of the funds had long-term outperformance and that nearly every single one of the successful funds underperformed in at least five of the years during the period studied.
The Bottom Line
The ETF market has evolved and now offers considerable benefits over mutual funds. Selecting the proper ETFs for your situation and then creating an asset allocation that can help achieve your long-term goals may be a better and more cost-effective solution.
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