Although mutual funds offer a package of professional management and diversification, they also have significant problems, including high fees, hidden costs, uncertainty of holdings and uncertainty of taxes.
Volumes have been dedicated to explaining and uncovering the costs of mutual funds,[i] and there is little to add to the comprehensive critique provided by the writing career of John Bogle, father of The Vanguard Family of Index Funds. Nevertheless, there are a few points that are germane to this discussion.
Many individual investors diversify their investments by putting their money in one or several mutual funds. Typically, actively managed equity based mutual funds without commissions (no-load mutual funds), pay about 1% each year inside the fund, to manage and operate the fund. In addition, transaction costs to buy and sell the stocks that the fund owns adds another (undisclosed) 1% to an investor’s cost to hold that investment.
When investors decide to liquidate their shares, and managers sell shares to provide cash for the redemptions, the fund may sell stocks for a gain. That sale triggers a taxable event. Now every investor must pay a share of the taxes from that gain, (whether the investor has been a shareholder for ten years or ten days). That tax cost can be an additional 1.5% of your investment each year. Add it all up and the annual cost of mutual fund investments can easily be 3.5% or more, not including any load fees, if the fund was purchased through a broker and a commission was charged for the purchase.[ii]
In general, the individual investor has little understanding of the impact of these fees on net return. “Just 43% of investors said they understood their adviser’s fee structure ‘completely’ or ‘fairly well,’ according to a survey by Boston-based State Street Corp.’s investment management arm, and [email protected][iii], a business journal at the Wharton School of Business.
Fortunately, there are a number of services that can provide assistance in this area. One particular source that I recommend investors examine when reviewing their mutual fund holdings (or prospective holdings) is a website: http://www.personalfund.com. Here you can put in the name or symbol of your mutual fund to discover the true cost of ownership.[iv]
Mutual Funds and Fear of the Unknown
Another problem with mutual funds stems from an investor’s fear of the unknown, what has been observed in Behavioral Finance as, “aversion to ambiguity.”[v] With the explosion of investment vehicles such as derivatives, aversion to ambiguity has caused investors to demand more transparency in their portfolios.
Arguably the greatest uncertainty problem that mutual funds cause is taxes. Mutual funds pass through all of the income and capital gains to shareholders; yet, they cannot pass along losses. In addition, shareholders typically aren’t aware of these tax consequences until late in the year. Many funds wait until December 31st to make their capital gains distributions known. That doesn’t give the investor enough time to make adjustments.