- A false sense of diversification: This is probably the biggest thing we see when we do an x-ray on a new or potential client’s portfolio. The client will come in owning 4-5 different funds from XYZ company and think they are well diversified. What we frequently see is that those funds they think are providing diversification all have the same investment mandate and very commonly the same investment manager and investments. For example, the client may own XYX growth, XYZ growth and income, and XYZ investors. What the client doesn’t realize is that these funds all own the same stocks and are all large cap growth funds. So instead of being diversified, they now have a portfolio that is concentrated in one style of investing and in the same stocks in all funds. Any investment in a properly diversified portfolio should serve a purpose in terms of diversification, and this is a common mistake made by people who invest in one family of mutual funds.
- Investing decisions are not made with the client’s goals in mind: The goal of a mutual fund portfolio manager is to maximize performance within the investment mandate of the fund. The fund’s investment decisions are driven solely by numbers and the fund manager does not know or care about the impact of those decisions on your individual situation. Investment decisions are not made based on your individual cash flow, tax or risk situation.
- Mutual funds are not tax efficient: While this does not matter if the fund is owned in an IRA or 401(K), if you own mutual funds in a taxable account, the investment decisions made by the fund manager have a large and direct impact on your individual tax return. For example, many fund managers will take profits near the end of the year to boost the performance of the fund. When they take those profits, this creates a capital gain for the fund holders that is reported as taxable income whether they took the money out of the fund or not. Again, the fund manager doesn’t care that those profit taking decisions just threw you into a higher tax bracket, caused your Social Security benefits to become taxable or increased your Medicare premiums. Their only concern is to maximize the return of the fund. The portfolio turnover in a mutual fund will directly impact your tax return.
- Mutual funds are not as cost effective as newer investment vehicles: All mutual funds (even no-load) have underlying expenses. There is a cost to have a portfolio manager, to provide customer service and reporting, and all funds have marketing expenses. These costs are all included in what is commonly called an expense ratio. You do not see these costs because they are paid before any return is provided to the fund holders. The only thing that is transparent is that they must publish the expense ratio of the fund. The average expense ratio for mutual funds is about .55%. This is an average, so some (like Vanguard index funds) are much lower in the .10-.25% range while others (actively managed funds) can be as high as 1.5% or more. In addition, if the fund is not a “no-load” fund, you could potentially pay as high as 5.75% sales load up front. Paying a front sales load may reduce the expense ratio, but even sales load funds have ongoing expenses. Plus, if you are paying an advisor to select mutual funds for you, not only are paying the fund company their expense ratio, you are also paying the advisor an investment management fee. This can raise the overall cost of the investment to as high as 2% or more.
When I started my career in financial planning way back in 1986, mutual funds were the best way to provide clients a well-diversified investment portfolio. The creation of mutual funds allowed clients of more modest wealth the opportunity to invest in a broad basket of stocks and bonds with professional management, which really opened investing to the masses. Prior to mutual funds, you had to work with a stockbroker and had to buy lots of 100 shares of any particular stock, so diversification was very difficult to achieve. As an additional benefit, no-load mutual funds allowed investors to buy directly from the fund company thus further lowering the cost of investing. So, for the first 20+ years of my career, mutual funds were the gold standard of portfolio management, and I used them almost exclusively.
However, looking back at the 80’s again, cassette tapes were also the gold standard of listening to music. While a big improvement over the clunky 8 track, they were gradually replaced by the superior compact disc. Ultimately, compact discs have been replaced by streaming services like iTunes and Spotify. The point is that progress ultimately relegates these prior disruptive technologies to the trash bin as they are replaced by newer technologies. This is no different in the investing world too.
Technology has also brought advances to investing, first with the introduction of exchange traded funds (ETFs), and now new innovations like fractional shares and direct indexing. What these have done is to make the tried-and-true mutual fund an outdated and obsolete form of investing. Mutual funds are much like VHS tapes that have been replaced, first by DVDs, and now by streaming services.
Unfortunately, we still see that a majority of new clients come to us owning a portfolio of mutual funds. There are several issues that we frequently see with clients holding mutual funds:
