August 2012


Author: Robert Star

For the majority of individual investors, actively managed mutual funds seem like a great idea. You get the benefit of investing while letting someone else make the decisions. After all, they’re supposed to be experts in their field. This may sound like a good idea, but here are some of the disadvantages of mutual funds:

1) Failure to beat their markets. Historically, most mutual funds fail to beat their respective indexes. This doesn’t mean their managers are inept; it just means beating the market is hard to do when you have so many restrictions. Mutual fund managers have strict investment policy guidelines and usually have to be fully invested at all times. They may keep a small portion in cash, but the majority of funds will stay almost fully invested regardless of market conditions. When the market tanked in 2008, fund managers had to stay invested. This puts the onus on the investor to determine when it is a good time to be invested or sitting in cash.

2) Lack of flexibility. While an individual can buy anything that’s traded, mutual funds are often prevented from buying stock in companies that do not match their investment policy criteria. For example, a large cap manager cannot invest in small cap stocks, regardless of the opportunity. It is also difficult to trade a large fund. The bigger the fund, the less limber it is. I always use the example of steering a large ship versus a small boat. Large funds have large individual positions that take time to trade in and out.

3) Tax consequences. When investors panic and sell their mutual funds, seeking to redeem their shares, mutual funds are often forced to sell good stocks and realize capital gains in order to meet the redemption demand. This hurts those who have continued to hold the fund, since they must pay tax on the distributions, even if the overall value of their shares has dropped. Investors may have had no positive return on the fund but have a tax liability at the end of the year. This does not seem fair, but investors in the fund own shares of the fund, not the underlying stocks. If you are going to invest in mutual funds, keep them in your IRA to prevent this tax liability.

4) Management changes. You may be happy with the performance of your fund, but if your fund manager moves on or retires, he or she will be replaced. Miss that news, and you could be left wondering why your performance has changed.

5) Fees. In the worst-case scenarios, you may foolishly stock up on load funds, which charge you a hefty fee just to buy into the fund. Other funds clobber you on the way out. These would be A or B shares. But even funds without loads may charge big management fees or other egregious fees that do not get reported. Investors would be shocked to learn about the hidden fees generated when stocks are traded with markups instead of commissions. This is how the traders and fund managers pay back their brokers for expensive dinners and sporting events. It will usually cost you less to acquire stocks or ETFs through a broker than through a mutual fund.

Alternatives to mutual funds
Of course, your choices aren’t limited to traditional mutual funds. Here are some other alternatives when you don’t want to do your own management:

1) Index funds. While an index fund is a type of mutual fund, it’s a passive one. Since it merely tracks a given index, your results will come close to matching the index. There are fees, of course, but they tend to be very low. Index funds also do fewer redemptions in most cases, so your taxes are less likely to be a problem.

2) Exchange traded funds. This is also a type of mutual fund, but one that is traded on the open market. As a result, you can sell exactly when you want to instead of having to wait for the day’s closing price, as with a mutual fund. There are exchange-traded funds that track a given index and hybrid products that try to throw in a little active management.

3) Closed end funds. Closed end funds are also traded on the market, but there are only a fixed number of shares. The price of the shares varies according to supply and demand, rather than just according to the performance of the market. As a result, the price of these funds can often drop substantially below their net asset value, allowing the savvy investor to pick up a bargain.

4) A financial manager. You could just turn your money over to a company or a broker that will manage it for you. You can establish a separately managed account that allows you to have a manager buy and sell on your behalf, and you will see the actual shares in your account, not just the shares of a mutual fund. This way, if other investors want to sell, it will have no impact on your holdings or tax liabilities. You may also find a manager who is willing to pull you out of the market completely when the market is in a down cycle. This type of relationship usually requires a larger minimum than mutual funds but is a good alternative to outsourcing a financial manager.

Wall Street is full of investment products for retail investors. Sophisticated institutional investors do not invest in the funds available to retail investors. You have to be careful when a firm tries to sell you the “fund of the day” that it meets all of your short- and long-term goals. If you enjoy learning about the stock market and have the ability to master your emotions, you may be surprised at how well you can do by picking your own stocks. If stock picking isn’t for you, take a look at some of the alternatives to a traditionally managed mutual fund. But no matter which direction you go, remember that diversification is not just large cap and small cap stocks or even bonds versus stocks. Because when the overall market goes down there is usually no place to hide. Really good diversification calls for much more than mutual funds.

Robert Star is managing director of EDI Financial Group. For more information, call (843) 815-6636.

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