10 Things You Should Know Before Investing in Mutual Funds

It probably wouldn’t surprise you to know that I am not a fan of mutual funds. That’s why I run a Spoke Fund®, after all. What’s wrong with mutual funds? Let’s start with…high fees, hidden costs, kickbacks, frequent trades, style boxes, a lack of candor and chronic underperformance.

While there are some good funds out there run by true stewards, with a few exceptions, most mutual fund companies long ago abdicated their real fiduciary duties. Mutual funds are, in short, a good idea gone wrong. As John Bogle once said in reference to mutual funds, “The scandal is not what’s illegal. It’s what’s legal.”

Here are ten things all investors should know before investing in mutual funds.

1. Expense ratios don’t tell the true cost.

A mutual fund’s expense ratio represents the cost of owning that fund. The expense ratio is made of numerous different costs and has become the standard way by which funds’ costs are compared. Unfortunately, it does not include all of the costs that are relevant to investors. Expense ratios often understate the true costs – sometimes dramatically.

Expense ratios ignore three key costs to investors – trading commissions, taxes and sales charges.

According to the Investment Company Institute, the average expense ratio for a domestic actively managed fund is 1.46%. That does not include, however, an average of another 0.27% in fees eaten up by trading commissions. Sales charges, or loads, can also cost up to another 5% in fees. A Morningstar study also found that the average mutual fund investor’s after-tax return is almost 2% per year less than the advertised pre-tax return.

In total, the actual costs to mutual fund investors could be an additional 2.3% to 7.3% on top of the stated expense ratio.

That is simply a huge difference.

2. Other investors can hurt your returns.

Mutual funds are giant pools of money. Upon investing, your money is effectively poured into the same pool that contains billion dollar investments from large institutions. In theory, this is a good thing, as it enables small investors to benefit from the cost savings offered to large institutions. In practice, it doesn’t work quite so smoothly.

When large investors want to take cash out of a mutual fund, the fund’s manager may have to make costly and unprofitable trades to quickly raise that cash. For very large funds, the act of selling a fund’s holdings to raise that cash can depress the share prices of those stocks held by investors still in the fund.

To add insult to injury, those investors who don’t cash out will bear the costs of the considerable tweaking a mutual fund needs to do to its pool after large investors leave. The net effect is that the returns of long-term investors are hurt by the decisions of other investors in the fund.

3. Your fund might be playing favorites.

A mutual fund typically accumulates a position in a company by buying shares in increments through a series of transactions. It is up to the mutual fund company to allocate those differently priced shares equitably among all its investors. To constantly allocate the lowest-priced shares to the biggest investors would be unfair to the little guys.

Despite plenty of company policies, it’s apparently hard for some fund companies to treat all investors fairly. After all – remember that little scandal back in 2003?

4. Turnover and taxes can be a real drag.

Turnover is the percentage of a fund’s holdings that change over a year due to buying and selling. The turnover of the average actively managed mutual fund is approximately 85% (or perhaps even higher, as per this post).

That means the average mutual fund holds a stock for just 10 months. That constant buying and selling takes a big toll on returns due to commissions and spreads. In addition, high turnover effectively forces more yearly capital gains taxes onto fund investors, further impacting returns. Turnover and taxes can be the long-term investor’s worst enemies.

5. Beware the closet indexers.

A “closet index” fund charges high fees for a generic portfolio that acts like the broader stock market. In other words, you’re paying unnecessarily high fees. You could buy an index fund for similar returns with much lower fees.

How to spot these funds? The number of stocks held is a good place to start. How much added value can there really be when a fund manager invests your money in the 137th stock in his fund?

6. Fund classes are confusing on purpose.

You may have noticed that many mutual funds come in different classes. Class A shares typically have a heavy upfront sales charge and a low annual fee. Class B shares have a delayed sales charge. Class C shares have low sales charges but high annual fees.

The mutual fund industry loves multi-class structures. It enables them to sell their funds through the widest possible network of brokers. Investors, however, should be wary. Having different fund classes implicitly suggests that one is right for you when in reality, a no-load or index fund likely makes much more sense.

7. Most managers don’t eat their own cooking.

Less than half of all mutual fund managers actually own a single share in the funds that they run. If a fund’s manager does not believe in the fund, or if they are not willing to pay the same costs and taxes as their investors, why would you ever consider investing in that fund?

8. Mutual funds pay their costs with your money.

Inflated commissions, soft dollars, revenue sharing…you might be shocked to learn how funds spend the money you send them to invest. The most outrageous is called a 12b-1 distribution fee, which can range from 0.25% to 1.0% of your assets. This fee is used to pay for marketing, advertising and distribution.

In other words, you are quite literally paying for the ads and commercials your fund runs to try to sell itself. How does this help investors already in the fund? No one seems to know.

9. You may pay taxes after a loss.

The IRS requires mutual funds to distribute capital gains and dividends to its investors. By passing all tax obligations onto the investor, the fund itself is afforded special tax status. But investors may owe taxes on those distributions even if they don’t sell a share – and, surprisingly, even after a decline in value.

So what’s worse than seeing your fund drop by 50% in 2008? Having to pay taxes on that, too.

10. Once a mutual fund has your money, it’s outta there.

The mutual fund industry continues to grow despite effectively ignoring the vast majority of its customers. In the end, most people find it too much trouble to switch funds, and the fund companies know this.

But if you’re fed up with Wall Street, you might be interested in learning more about Spoke Funds. I built my portfolios differently to avoid all of these issues – plus a few more. You can learn more about the portfolios I manage at my firm’s site, IslaInvest.com, and you can learn more about Spoke Funds® here.

And did I leave anything out in the list above?

Update: Ben points out that I may be dramatically underestimating the internal trading/commissions costs of mutual funds as cited above. He says Edelen, Evans, & Kadlac’s 2007 study “Scale Effects in Mutual Fund Performance: The Role of Trading Costs” likely has better data – and they put the costs I estimated to be .25% at 1.44%, instead. Egads.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.

This entry was posted in For Investors and tagged , , , . Bookmark the permalink.