4 Ways Mutual Funds Hurt Your Retirement

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This post first appeared on Forbes.com.

Mutual funds are no small industry. More than half of all American households own a mutual fund, and according to the Investment Company Institute, assets totaled $11.6 trillion in over 7,600 funds last year. Of those assets, actively managed mutual funds made up over 90%. Mutual funds also cost Americans tens of billions in fees every year.

So why are active mutual funds so popular? They offer average investors professional management and an easy way to diversify. These qualities made them preferred choices in 401K’s and employer sponsored retirement plans, which further cemented their acceptance amongst the masses.

But times have changed. What were once unique advantages aren’t so unique anymore. Most mutual funds are now plagued by more drawbacks than benefits—they’ve become inefficient and largely outdated investment vehicles. Here are the four main reasons you probably shouldn’t own active mutual funds.

Poor Performance Relative to Indexing

The 2012 S&P Indices Versus Active Funds (SPIVA) Scorecard ranks the returns of actively mutual funds to passive S&P indices, and the results are clear. On a one-, three- and five-year basis, the S&P 500 outperformed 81%, 69%, and 62% of all domestic large cap mutual funds, respectively. The same trend is present across the mid and small cap spectrums. In fact, no ten year period exists where a majority of actively managed mutual funds outperformed their benchmarks.

So regardless of what mutual fund managers might claim, the reality is most leave their customers with less money than passive indexing. And diversifying across multiple funds isn’t the answer. Simple math dictates the odds of underperformance increase as more mutual funds are added to a portfolio. Investors should even be wary of managers with strong track records. History is littered with examples of star managers who attracted considerable assets and performed terribly thereafter.

Tax Inefficient

As detailed in one of Bill’s previous posts, mutual funds are extremely tax inefficient. According to Morningstar.com, the ten largest mutual funds by assets had an average turnover ratio of almost 75%. That’s a lot for a single year. And unfortunately for investors, this means higher taxes. Gains are distributed straight to shareholders (generally at the end of each year), and it doesn’t matter if you bought the fund in November. You’re responsible for the entire year’s taxable gains.

Mutual Funds Are Difficult to Manage

Many investors view actively managed funds as vehicles they can move in and out of depending on performance and market conditions. Unfortunately, they’re not good at it. Average investors often let emotions dictate buy and sell decisions, leading to the wrong investments at the wrong times. In other words, chasing winners and selling losers. Dalbar puts together an annual study of investor behavior, and recent findings support this theory. In 2011 alone the average equity mutual fund investor lost 5.7%, compared to the S&P 500 which was up 2.1%.

Excessive Costs

Actively managed mutual funds are expensive. According to the Investment Company Institute and Lipper, the average expense ratio of equity funds is 1.43% and the weighted average expense ratio was 0.79%. And this is just the beginning. Mutual funds carry additional visible and hidden costs. These can include sales loads, which are paid to the selling broker, as well as similar fees paid to the fund company. There are also embedded costs associated with trading, research, and potential market impact (hidden fees). Add these up and the real cost of owning mutual funds is often 2% to 3% or more. These are huge hurdles to overcome considering most funds don’t outperform their respective benchmarks.

Bottom Line

Active mutual funds are inefficient, expensive investment vehicles with a track record of poor performance, and they’re difficult to manage. There are better ways to invest.

Passive index funds can be good investments, just make sure they’re the right ones. Costs vary widely depending on the fund company. Exchange traded funds (ETFs) can be much better options. Similar to passive mutual funds, turnover is generally lower, meaning less taxes. They’re even set up differently than mutual funds—ETFs trade on the secondary market just like stocks. So unlike a mutual fund, the securities that make up the ETF don’t need to be sold in order to raise cash for redemptions. Again, this means greater tax efficiency.

All of this translates into lower costs for investors—much lower if done correctly. The key is eliminating as many headwinds as possible on the way to your financial goals. Doing so will significantly improve your chances of success.

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Brendan Erne, CFA
Brendan Erne serves as the Portfolio Management Team Leader with Personal Capital Advisors. He has over 15 years of industry experience, spanning almost all levels of the investment process, including several years at Fisher Investments as an equity analyst covering the Technology and Telecommunications sectors. He also co-managed a large cap growth portfolio and co-authored Fisher Investments on Technology, published by John Wiley & Sons. Brendan is a CFA charterholder.
Brendan Erne, CFA

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4 comments

  1. Timmy

    In a retirement account such as a 403b the income is not taxed so how are mutual funds tax inefficient in a retirement account?

    Reply
  2. BrendanErne

    Hi Timmy,

    You are correct, the tax impact would not apply in retirement accounts. But performance and fees alone are good enough reasons to consider alternatives to active mutual funds. Obviously this assumes you are offered a choice within the retirement plan, which may not be the case.

    -Brendan Erne

    Reply
  3. Spencer SparklePants Shepard

    This is the most BS and alarmist article I’ve ever read.

    1. Active vs Passive: Yes, obviously many funds get it wrong. If you’re investing for the long term (5-10 years or more), then perhaps 60-65% of mutual funds in a given category will do worse than their benchmark index. But guess what? Mutual fund selection isn’t a random process! All it takes is some basic research, and you can easily suss out some funds that are in the top 10th percentile of their category. In the true long-term of several decades, I’d much rather have an active fund than a passive one that just blindly invests in the index no matter what.

    2. Tax Efficiency: Active funds have a higher turn-over rate? You don’t say! Seriously, if you don’t even know how to invest in mutual funds via a non-taxable retirement account, then you have no business writing this article. Obviously it’s important for people to understand the costs of going active in a taxable account, but given the fact that I can invest up to $23,000 in my retirement accounts (401k + IRA) per year as an individual (or up to $46,000 once I’m married), there’s really no reason to worry about it. If I really have so much money that I can meet my contribution limits and still have money left over to invest, then I would be very happy indeed. But seriously, your audience is middle-class investors, 99% of whom will never have such an exciting “problem”.

    3. Difficult to Manage: This section is completely pointless, and it has absolutely nothing to do with mutual funds. People are bad at managing their investments… Who knew? You say that actual mutual fund investors lost 5.7% compared to the index gaining 2.1%. Okay, that’s great… what about people who actually invested in the index? Did they really gain that 2.1%? Of course not. People respond emotionally no matter what they’re invested in. If they buy their mutual fund high and sell it low, what makes you think things will be any different if they invest in a passive index instead? The only point here, if there is one, is that people need to educate themselves about the basics of disciplined investing, so that they can buy low and sell high without too many fears. Better yet, just use dollar cost averaging in order to remove any possibility of an emotional response. There is absolutely nothing specific to mutual funds that precludes you from doing this and thereby nearing your fund’s reported performance over the long term.

    4. Excessive Costs: First of all, the expense ratio is already accounted for in the performance numbers that mutual funds report, so it’s not like some magical hidden cost that needs to be accounted for separately. That said, I still prefer to invest in funds with an expense ratio as close to 1% as possible (or perhaps as high as 1.5% for high performance growth funds), since the managers do have to overcome that (admittedly small) barrier first before any actual returns are made for the customer. But again, if you find a mutual fund whose past performance numbers are better than its benchmark index, then yes, the costs are already accounted for and it really is “better”.
    Second of all, sales loads. Yes, some funds have sales loads, but many don’t. If you don’t like sales loads, then there are plenty of high-quality no load funds out there. Personally, I never invest in funds that charge a load, and yet my investments are doing great. Imagine that! However, the typical 5-6% sales loads only tend to have about a 0.75% impact on returns per annum over a 10 year period, so it’s still a viable option for long time horizons with a good fund. Furthermore, load funds typically report their performance numbers both with and without the sales load, so again, it’s not some hidden cost you have to guess about when researching. If you don’t like the “with sales charge” performance numbers, then simply find a different fund. Was that so hard?

    In summary, the worst thing about this article is that it assumes that if the “average” case looks bad, then there’s no way that the “better than average” case can look good. Yes, if you select your mutual fund at random, put it in a taxable account, invest emotionally, and/or pay for high expense ratios/sales loads when the fund’s performance doesn’t justify it, then “you’re going to have a bad time” (as ski instructor Thumper from South Park would say). But if you do your due diligence and select a fund with high performance and lower than average expenses (compared to other funds in the same category with similar performance), and furthermore you put it in a non-taxable account and use dollar cost averaging like a sentient human being, then mutual fund investing can be very powerful.

    *Mic drop*

    Reply
  4. Epic Research

    Absolutely the points are very true and it gives the clear understanding about the concerened topic, thank you posting.

    Reply

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