Mutual funds are among the favorite investment vehicles for “comfort”. As of January 2020, Americans have $21.3 trillion invested in mutual funds. Year after year, people continue to put forth their money and trust towards fund managers in the aspiration that an “expert” can outperform the market. So should investors who feel they don’t have the time and skill to manage their investments invest in mutual funds? The answer is certainly not. With high management expense ratios (especially those in Canada), significant barriers to exit, and tax implications you will find higher returns in a library of other investments. So why do people invest in mutual funds in the first place? Well, it’s easy to market a fund that claims to minimize losses in downturns. Just put “comfort” in the name and then, Hey look, everyone loves it now! But you’d be surprised to find out what they don’t tell you. I guarantee you won’t be too “comfortable” afterward.
When A Highschool Teacher Knows More Than The Adviser
Andrew Hallam is a high-school teacher and author of Millionaire Teacher. This was a relatively recent book I picked up and I was thoroughly impressed by what he’s been able to uncover. But then again, I’d guess a Millionaire Teacher could get a cup of coffee with The Intelligent Investor. Perhaps he also lives next to The Millionaire Next Door, across the street from The Wealthy Barber, and maybe two doors down from The Richest Man in Babylon?
I’m just kidding, only a thought.
On a serious note, in his book, Hallam unmasks the mutual fund investment industry after taking his mother to a local bank to help her open an investment account. They planned to have roughly 50% in a stock index and the other 50% in bond indexes. However, upon mentioning their intention, the adviser quickly tried to talk them out of it. Following several back-and-forths, the adviser realized Hallam knew more about investing than she did. She revealed that her training was a three week crash-course in which she finished in two weeks. Within the three weeks they are taught to sell. That is, they are provided with talking points to pressure and confuse investors into buying mutual funds. More shockingly, if they wanted to learn about diversification and asset allocation they had to do that on their own time. Essentially, they are equipped with tactics on selling with little to no knowledge of what they’re selling nor how it works.
The adviser went on to explain the process they follow for new clients. First they try to understand how knowledgeable the investor is. Clients who don’t know much are put in a fund of funds. this is more expensive than regular mutual funds because it includes layers of fees, thus adding a nice kick to the adviser’s personal account. For the investors who seem a little more intelligent, these clients are offered an in-house brand of actively managed mutual funds. These aren’t as profitable but still expensive due to high Management Expense Ratios (MER). Lastly, the advisers are to under no circumstance offer the bank’s index funds. This is the last resort for when they can’t talk the investor out of indexes. When the client insists on it, only then will they look at index funds or low-cost ETFs (exchange-traded fund). For my money, this should be illegal. The ridiculous investment vehicle is principally trying to make as much money as they can from your investment.
High-Paying Profession With a Lack of Transparency
Investment advisers constantly use juiced numbers and logical arguments with huge holes to justify their means. Why? There is a basic and simple reason for this: they make millions and millions of dollars off of recommending mutual funds and other advantageous investment products. In contrast, they have nothing to gain by advocating for an indexed investing approach. They rarely get paid (if at all) when you buy stock market indexes. That’s why advisers will desperately try to steer clients into a more “profitable” direction. A survey conducted by Russel Reynolds Associates revealed that fund managers who work at mutual fund companies make on average $436,500! With such a salary it’s no wonder they need more clients. If you asked a fund manager they would tell you that actively managed mutual funds are the way to go. But they probably won’t mention that immense mortgage on their $12 million beachside home, or the latest Jaguar they want to buy. You need to help them pay for these things. Thus they are merely salesmen cloaked as expert advisers. When taking into account the lack of transparency, most fund managers do not disclose their salary. Why? Well maybe because they don’t want to discuss all the layers of hidden fees behind their funds. As a matter of fact, when they do reveal salaries, they come in lengthy documents with no simple language to state the amounts they make. This sparse language makes it hard for investors and the public to understand the details of overall reporting of salaries.
Furthermore, your mutual fund manager is paid regardless of how well your investments perform — yes, even when you lose money. Personally, I wouldn’t let an “expert” who takes on no risk make investment decisions for my future. Heck, you don’t even know if the “expert” is good until you withdraw your money years later.
Index funds are benchmarks for active fund managers. They will buy and sell selected stocks repeatedly, trying to beat passive funds with active funds. It sounds strategic but evidence shows that these benchmarks constantly outperform any mutual funds. In a 15-year-long US study published in the Journal of Portfolio Management, stock market mutual funds were compared with Standard & Poor’s 500 stock market index (S&P 500 Index). After survivorship bias, taxes, and management fees were taken into account, the results of the study were as follows: 96% of the mutual funds underperformed the S&P 500 Index.
Another study conducted by S&P for 16 years (as of March 2019) had similar results. For the ninth consecutive year, active fund managers have been trailing the S&P 500. In 2018, active fund managers claimed they would do better during the periods of heightened volatility, but it seems like they’ll need to find another argument.
That year the majority (64.49%) of large-cap funds fell behind the stock market index. Furthermore, the investigation revealed that after 10 years 85% of large-cap funds would fall behind the index, and after 15 years almost 92% are trailing S&P 500.
“Active managers claimed that they would outperform during volatility, and it didn’t happen,” said Aye M. Soe, a managing director at S&P.
The exorbitant expense ratio is like running a marathon while dragging a speed chute on your back.
Despite everything, your adviser might not back down and perhaps continue with something like: “I can show you our mutual funds that have beaten the index in the past 20 years, we promise to only buy you the best winning funds.” Well, forecasting by looking at only historical data is like driving and only looking in the rearview mirror. Academic studies shows that well-performing mutual funds never last, and in most cases they will flop in the next year or two.
So if you need a comeback, ask the adviser this: “ All these funds have beaten the market in the past and you say you can pick just the winners? Could you show me your personal investment statements from 20 years ago? If you prove that you owned these funds back then I’ll invest with you.”
Okay, that’s a bit harsh, but you aren’t likely going to see any of the winning funds from 20 years ago in his portfolio report.
As a result, as fund managers continue to fall short from their benchmark, it is evident that investing in low-cost index funds remains the soundest long-term investment.
When an active fund performs poorly investors back away and current customers flee the fund for healthier investments. When this happens the fund will merge with another fund, and if not it will shut down. Let’s use the Lindner Large-cap Fund as an example. It out-performed the S&P 500 for 11 years until 1984. But you won’t find this fund today because for the next 18 years the active fund made roughly 4% annually compared to the S&P 500 with a 12.5% annual gain. Finally, in 2002, they merged with Hennessy Total Return Fund, and the previous track record was erased. Countless titles compare index-performance track records with actively managed funds, but most of them will not account for survivorship bias, taxes, and other expenses.
Expense Ratios, Sales Commissions, Taxes & Trading Costs
Many factors are dragging down your returns from active funds. Some may ask why they never see these cost liabilities being mentioned in their mutual fund statements. Except for the sales commission and expense ratio — the rest is hidden from view in minuscule print.
- Expense Ratios
The cost correlated with running your mutual fund is expense ratios. Every time you buy into an active fund, the salary of the analysts or trader is paid by hidden fees. The average expense ratio of large-cap funds is 1.25% , and 1.4% for small-cap funds, compared to passive index funds with an average expense ratio of 02.-0.5%. As mentioned earlier, these are some of the highest-paid professions, and so they are expensive to employ. Oh, and did I mention you’re paying for the office lease, electricity, compensating salespeople, and maintenance of their computers. Then there are the owners of the fund company. They take about 1.5% of total assets (for US funds) in expense-ratio fees. For example, if the fund holds a total of $20 billion, it would cost the investors $300 million every year. This expense isn’t enumerated for investors to see and the amount comes out even if the mutual fund doesn’t make any money.
2. Sales Commissions
Lots of fund companies will charge load fees. These are a percentage upfront to buy the fund or a fee to sell the fund. These commissions go straight to the salesperson and can be as high as 6%. The penalty fee is usually charged if you remove your money before 5 to 7 years. For the salesperson, these loaded funds add a nice kick to their account. But for the investors, it isn`t such a great deal. Charging this bulking sum means you need to double your investments the next year. They argue that these fees are put in place to keep you from panicking when the market changes rapidly and become volatile. Basically, you’re paying a fee to protect yourself from yourself.
3. Taxes & Trading Costs
When actively managed mutual funds make money in a certain year, the investor must pay taxes on the gain. Over 60% of the investments in US mutual funds are in taxable accounts. Taxes are paid because in an active fund the fund manager is actively buying and selling stocks trying to gain an edge on the market, and if they generate profit then at the end of the year you will get a bill for the realized capital gain. For every trade there is a sales commission. On average it costs 0.2% annually or $40 million on a $20 billion fund. Both fluctuate year to year, varying by how much buying and selling the manager does. This is what makes one fund less tax-efficient than the other. These mutual funds also have something known as a “100 percent turnover”. This is when a mutual fund trades every stock it has during an average year. A significant amount of the trades made will trigger short-term capital gains. This is a hefty penalty that the investors will have to pay. Also, few fund managers seem to care.
4. 12B1 Fees
12B1 fees can cost up to 0.25% or $50 million on a $20 billion fund. This fee pays for any marketing expenses such as online ads, magazines, newspapers, and TV ads. The expense is paid for by current investors to lure in new investors. Not much explanation needed: this fee is not included in the financial advisory statement either.
Actively Managed Funds Against Index Funds
Let’s compare mutual funds with their benchmarks: index funds. The following are compared in the table I made below.
When you put things into perspective and have the comparisons in front of you, anyone with a two-digit IQ would know mutual funds are nearly a rip-off. And for indexes, well, next to active funds they’re a no brainer.
So at the end of the day, is the “comfort” of mutual funds the advisors try and sell you worth it? Is it that comforting knowing that some advisors could just take a three week crash course on selling and get the job? And if you’re saving for retirement, you won’t know how the “expert” may perform until you finally withdraw your money years later. My goal here was to shed some light on aspects that advisors won’t tell you about. If you’ve received some helpful insights out of this, or if it has helped you decide on an investment vehicle, my goal has been fulfilled. But of course, I would highly recommend that everyone educate themselves and read up for their own benefit. Because in the end, no one cares more about your finances than you.