More on Mutual Funds

Mutual funds are one of the most popular investment options today, used by both individual investors and professional advisors. But they are some of the least understood.

Mutual funds are touted as offering consumers professional management, diverse portfolios, and low cost. On the surface it sounds good, but how much of it is really true?

Shareholder Interests and Fund Manager Interests Are Not Aligned

The biggest problem with the mutual fund industry is that the interests of the mutual fund company and mutual fund managers are not aligned with the interests of the mutual fund investors (you, one of the shareholders.) After all most mutual fund companies are for-profit enterprises. (Vanguard is a notable exception in that it is shareholder owned.) Mutual fund companies and managers benefit from charging higher fees while investors benefit from lower fees. Mutual fund companies and managers benefit from having as many assets as possible under management (because their fees are charged as a percentage of assets) while investors are better served by smaller funds.

Preferred Funds Are Preferred for Another Reason

Ever wonder how some advisors decide which funds to recommend? Or why certain brokerages have preferred families of mutual funds? Many mutual fund companies simply pay the firms or advisors fees to have their fund families become the firm’s recommended funds. Recommendations are not made because the firm has done extensive research and determined these are the best mutual funds for clients; rather, the firms highlight them because they just received a few big checks from that fund company.

Most Funds Create Massive Tax Problems

Unless you hold mutual funds in a tax-advantaged account (such as a 401(k) or IRA), mutual funds are probably causing you to pay more taxes than you should. Fund turnover, the amount of assets a fund buys and sells each year, has been increasing mostly due to increasing pressure to outperform benchmark indexes over a short time period, such as quarterly or yearly. The average turnover now stands at more than 100%, meaning a fund buys and sells all of its holding once a year. Each time a holding is sold, the mutual fund shareholders are taxed.

The chart above shows just how much this short-term strategy can cost in taxes. The Buy and Hold investor buys one investment that returns 10% and holds it for 20 years. The Sell Every Year investor buys an investment that returns 10% at the beginning of the year and then sells it at the end of each year for 20 years. Both investors start with $10,000. At the end of 20 years, the Buy and Hold investor has $58,683.75 while the Sell Every Year investor has $44,452.26. (This assumes a 30% tax bracket and 15% long-term capital gains tax.) While buying and holding an investment for 20 years may not be practical or even advised, adhering to an investment strategy that minimizes turnover is in any investor’s best interest.

Mutual Funds Rarely Tell the Whole Truth

Do you read the prospectus of a mutual fund and think you have a good understanding of what the fund can and can’t do? There is another document that almost no one bothers to read, the Statement of Additional Information. This is where the deep dark secrets of funds are kept hidden behind a veil of dense legalese and confusing financial terms. One very popular fund with tens of billions of dollars tells investors in the prospectus that they invest primarily in stocks, bonds, and cash. Only when you read the Statement of Additional Information do you find that the fund may also invest in derivatives, foreign currency transactions, and illiquid securities. Do you know if your mutual funds have any secrets they don’t want you to know about?

Stale Pricing Costs Shareholders Money

Another downside to mutual funds is this: Buy-and-hold investors lose profits to short-term traders through “stale pricing.” Shares of mutual funds are priced once a day at market close at 4PM. However, many securities the funds own trade throughout the day in after-hours trading. Traders can buy shares of a mutual fund at the cheaper closing price knowing that the underlying securities are now worth more and the value of the mutual fund’s shares will open higher when trading begins the next day. In fact some mutual funds strike agreements with these traders allowing them to move money in and out of the fund at the expense of buy and hold shareholders. Recent regulation changes have curbed some of this behavior, but it is still prevalent in mutual funds that invest in foreign securities where timezone differences add to the problems.

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