Conventional wisdom holds that investors should avoid individual stocks and instead purchase mutual or index funds. While the reasons for owning mutual funds can be quite compelling, – greater diversification and improved return – investing in this type of asset present several disadvantages that most investors are not aware of, especially when compared to direct ownership of stocks.
Fees and Return:
A typical mutual fund can charge you upwards of two to three percent in management, distribution (12-b) and operating fees. In addition, many mutual funds also charge a sales fee or load. Even some no-load funds have sales fees or incentives for brokerage houses to push their fund, so even with so called “no load” funds there are implicit fee structures built into their prices.
Provided the funds management is good, fees are not necessarily a bad thing. However, it is important to recognize the impact that fees have on your profit. Lets say you invest $10,000 and it gives you a 9% return. At the end of 10 years you’d have $23,673.64. But, assuming you are charged a 2% annual fee, then you would only have $19,671.51 ten years later. Your 2% fee would have cost you a bit more than $4,000. Four grand is rather a lot to pay for management.
On the other hand, to purchase shares of stock, you’d pay roughly $0-100 per trade.
A second disadvantage to mutual funds is unclear valuation. The mathematics surrounding the calculation of pricing for mutual funds – known as Net Asset Value (NAV) is complicated. This suggests that a specialized set of knowledge is required to understand the value of your investment. This is a problem because when you purchase mutual funds you are essentially reliant on your funds management staff to determine the value of your investment. Valuation methods are less of a problem with exchange trades funds, and it is probably safe to assume that the mutual funds management is honest, but shouldn’t you be able to easily determine how much your investment is actually worth?
On the other hand, if you own a stock, its value is easy to determine, just check the quote online.
Mutual funds managers vary in their quality. Some are good, some are bad, but most are just average. A bad manager can really ruin your investment. This is a lesson I learned the hard way. Back when I was starting to invest in 2000, I put a couple of grand into a Smith Barney Mutual fund. The fund lost promptly lost 20% of its value and Smith Barney was later sued for management improprieties related to their mutual funds.
Assuming however, that you manage to avoid a bad mutual fund manager, there are still significant challenges relating to management. First, it is very difficult for even good fund managers to consistently beat major stock market indexes. Second, many good money managers are no longer in retail mutual funds. Post 2003 there has been a “brain drain” from mutual into hedge funds. Hedge funds offer greater flexibility, higher profits and less regulation than mutual funds. Accordingly, many of the best financial minds left the retail mutual fund industry. On top of these challenges, you’ve got to pay the fees. So, why pay for what will probably be mediocre performance?
On the other hand, if you directly own stock you have can always improve the performance of your own manager – you!
Finally, we should disclose that we do invest in mutual funds. James has shares in the Vanguard S&P 500 index and Miel owns units in the ING Direct Real Estate Class O fund. So, while this asset class does have some drawbacks, we are both heavily invested in it.
P.s. Click here for the SEC’s explanation of fund fees.