The Mutual Fund Scam In case you haven’t already guessed. I am not a fan of mutual funds. I have butted heads with my professor in my college personal finance class more than once over this issue. Despite my being bull headed, and challenging a man who has probably devoted his life to studying and understanding this stuff, he did give me an “A” in the class. Honestly, I think that he gave it to me just to avoid the argument that I might raise.
You might question my judgment on this issue. At the very least you want me to explain why I feel that mutual are a poor investment. As we have already discussed, money and investments can be a very emotional issue. Someone who is heavily vested in mutual funds might take offense to what I have to say. It is tough to admit that one is wrong or be perceived as foolish when they feel that they did the right thing. In fact, according to many leading professionals in the field, they did do the “right thing”. The problem with this is the fact that those very professionals are either benefiting from that information, or are holding to the teachings and education that has been pounded into their heads by those that directly benefit from that information. In other words, the experts are either Crooks or Clowns. For their own karma I hope they are clowns; but I’d rather deal with neither. Please don’t misunderstand me; I don’t think that everyone who works in that industry is a crook (Mr. John Boggle has taken great strides to bring integrity back to the industry) and I don’t think that everyone who invests in mutual funds is an idiot…Just misinformed.
Before I jump on my soapbox lets talk about what a mutual fund is. A mutual fund is a pooling of investment capital from numerous investors that is run by a Fund Manager. This manager (who is supposed to be a financial genius) then invests the pooled capital into various securities based upon his knowledge, experience and the fund criteria. The idea behind this concept is that the individual investor cannot afford to properly diversify and even if he could he would not know how to properly manage those investments. By letting an “expert” do the investing for you, you will reduce the risk and increase the return because your manager will keep you hard earned $$$ out of losing investments and only hit winning investments…thus beating the market in overall returns.
This all sounds good in theory but now it is time to burst the sunshine and lollypops bubble. First, mutual funds cost money…a lot of it. Most of you that are familiar with mutual funds understand this as a “load”. A Load is a fee that fund charges you for doing business with them. You are literally paying for the privilege to get your money back after you let someone else play God with your earnings. But some would say that the manager needs to be compensated for his talent and skill; after all, he is doing a job for us. Well here is a fun statistic from Money magazine. This past year 95% of fund managers failed to beat the market. 90% failed to break even with the market. That means that only 5% of the fund managers did what they are supposed to do…beat the market. And those that did beat the market have failed to do so on a consistent basis. So now the question is, “What in the heck are we paying them for?” I also get a kick out of the phrase “beat the market”. If the market takes a 75% nose dive and your fund manager manages to only lose half (50%) of you life savings, he falls into the category that “beat the market”. In fact he beat it by 25%. Hey folks, I don’t know about you, but I can blow half of my cash without any help form anybody; and I can tell you that I would have a lot more fun doing it!
I touched on my next complaint with the mutual fund industry in the previous paragraph…costs. I have mentioned Loads (also called redemption fees), but there are also Transaction costs(the cost of actually trading), 12b-1 Fees (what a mutual fund charges to cover it’s advertising), soft dollars (this comes from some “creative accounting”), unnecessary taxes (most funds are not managed for taxes), advisor fees (paid to an advisor who “recommends” various securities). What’s worse, most of these costs do not even have to be reported to the investor. And the SEC thinks that is perfectly fine…well… “legal” anyways. These expenses could easily total 3-4% a year.
That may not sound like much but let me give you a little longer-term example: An individual who's 20-years old today, is starting to accumulate for retirement.... That person has about 45 years to go before retirement -- 20 to 65 -- and then, if you believe the actuarial tables, another 20 years to go before death mercifully brings his or her life to a close. So that's 65 years of investing. If you invest $1,000 at the beginning of that time and earn 9 percent, that $1,000 will grow...to around $140,000. Now the mutual-fund system will take about 3.5 percentage points out of that return, so you'll have a net return of 5.5 percent, and your $1,000 will grow to approximately $30,000 to you the investor.
Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return. And you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return. That's a financial system that's failing investors because of those costs of financial advice and brokerage, some hidden, some out in plain sight, which investors face today.
The problem with mutual funds is their fees. The longer you invest in a mutual fund, the more you pay in fees. I've pointed out before that when I buy a stock, I pay the sales commission once, but when I purchase a mutual fund, I pay a sales commission for as long as I own the fund. That's why the return on investment is much lower on mutual funds -- and why gains get lower the longer you own them. The reason most financial planners recommend you invest for the long term is simply because the longer you hold on to the fund, the more money they make.
Most financial experts don't know how much a mutual fund's fees and expenses are as most funds aren't required to disclose all such charges. In other words, there's no transparency. If you really want to be a passive investor, you may want to consider investing in index funds, which Vanguard, specializes in (though not exclusively). Simply put, index funds have lower fees so the investor has a chance of making more money. After all, isn't that why we invest?
While index funds have the potential of generating greater returns via lower fees, I would still prefer to be an active investor. Most index funds think a 8 percent to 12 percent return is a good rate. Active investors can regularly beat those gains. Especially if you demand that every investment that you make is completely transparent. You should be able to clearly see every important working element within an investment. This allows you to take the calculated risk with your money because you are fully aware of all the risks, rewards and functions within an investment.
My last issue with mutual funds comes from the sector called “socially responsible” or “green” investing. The sales pitch is that these funds only invest in companies that are moral and ethical in relation to the community and the environment. They are quick to say that they will not invest in any company that harms the environment, employs slave labor or has any relationship with violence or corruption. Usually the people that tell me about their investments with these funds will state that they don’t want their money funding companies in oil, tobacco, gambling, alcohol, or defense contracts; and I shouldn’t have my money working there either because that is simply supporting corruption.
I have a real problem with someone else telling me what my morals, values, or ethics should be. As a soldier, I don’t have a problem with companies that clothe, equip, and feed me and my fellow soldiers. I like and enjoy playing poker and blackjack. And by god…I drive a car that runs on gas (so does the schmuck that says that such investing is unethical)
I must confess though I do look through the prospectus on the socially responsible funds. I do like investing in companies that have made the effort to be viewed as doing some good in the world. For whatever reason, these funds feel that their selection of companies have raised the bar; and I want to see what those companies are. If they fit into my LIVE analysis and pass my SOAP(which we will discuss in a future lesson) analysis, they are on my watch list.
Hopefully by now I have convinced you that you can do your own investing and be successful and do not need to rely on mutual funds. If however you insist on carrying some in your portfolio or you have to because you are participating in your company’s 401k I will discuss how to properly do in the next lesson with either Dynamic Dollar Cost Averaging (better than dollar cost averaging) and The Automatic Money Machine. Be forewarned…there is a fair amount of math involved; but I promise…no algebra.
I will step off my soapbox now.
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Contributor's Note
Now for my legal disclaimer…
These lessons are designed to provide accurate and authoritative information in regard to the subject matter covered. All investing involves risk. One must be aware of the risks and be willing to accept them in order to invest in the stock and options market. Are you seriously reading this? This information will be provided for educational purposes only and no warranties are given or implied. As I am not a licensed legal, accounting or financial advisor, nothing I give will be a recommendation or solicitation to buy or sell the securities mentioned. Why are you reading this? Everything shown will be solely for illustration purposes only. If legal advice or other expert assistance is required, the reader is encouraged to seek the services of a competent professional. As always one should conduct your own research prior to any trading decision. Still reading? Any decision to place a trade is one’s own responsibility. The author and the owners/moderators of this forum are not liable in any form for independent trade decisions. Why are you still reading this?
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