If you are looking to build an investment portfolio financial advisors will often advise you to put in your money into a mutual fund. That way you have an investment professional managing your money and you don’t have to worry about it, as it is being taken care of. However, that isn’t good advice at all. In fact, you need to think twice before investing in mutual funds as actively managed mutual funds incur the highest fees (compared to other types of investment vehicles) and the majority of them do not outperform the market.
Mutual funds charge high fees
The first major drawback of investing in mutual funds is the high fees you incur, compared to other investment vehicles such as stocks, bonds, ETFs or index trackers. According to the Forbes article titled “The Real Cost Of Owning A Mutual Fund” independent financial advisor Ty Bernicke concludes from his research that the average cost of owning a mutual fund is 3.17% per year. That is the percentage you need to take off your annual percentage return each year!
While costs for mutual funds have decreased over the last few years (mainly due to the rise in popularity of low-cost ETFs) mutual funds will still charge you the highest fees amongst all of the main investment products. The main arguments by the fund management industry for the higher pricing is that “your portfolio is in safe hands as it is managed by a professional who will generate superior returns for you”. However, that is not the case.
The majority of mutual funds underperform the market
Not only are you being charged high fees for a portfolio manager managing your investments, but to top it off, the majority of fund managers do not outperform the market. Mutual funds are always set against a so-called benchmark. An example of a benchmark would be the S&P500 index for a US large cap stock fund or the MSCI World Bond Index for a global bond fund. The goal for fund managers is to outperform their benchmarks. That is what they are being paid to do. However, research has shown that the majority of mutual funds regularly underperform their benchmarks (i.e. the market that they are supposed to beat). So, not only do you lose returns as you are being charged high annual fees but the overall returns are often worse than if you were to buy the index that they are trying to outperform. So, what do you do?
Invest in low-cost index tracker funds or ETFs instead
The smart alternative is to invest in low-cost index tracker funds or ETFs (exchange-traded funds). Not only will they outperform the majority of actively managed mutual funds, but you will also generate higher returns long-term as you will save a chunk of money on fees. Index tracker funds, as the name suggests, are funds that track a specific index. As they are passively managed they incur much lower fees than actively managed mutual funds and, on average, perform better. ETFs are very similar to index-tracker funds, as they generally also track an index, but ETFs are traded on the stock exchange.
“The goal of the nonprofessional should not be to pick winners — neither he nor his ‘helpers’ can do that — but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.”
— Warren Buffett, 2013 letter to Berkshire Hathaway shareholders
But don’t actively managed funds do better during a falling market? No!
Another argument that mutual fund managers like to make is that actively managed funds do better than index trackers and ETFs during a bear market (i.e. when the market goes down) as they can be more versatile and shift portfolio holdings around. However, research suggests that this argument doesn’t hold and that even during bear markets most mutual funds do not outperform their benchmarks.
As actively managed mutual funds charge you higher fees and, on average, underperform the market there is really no reason for you to put your money into a mutual fund. Look at low-cost index trackers or ETFs instead to invest in the segments of the market you want to be invested in.