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The Pros and (Mostly) Cons of Mutual Funds

Why buy a mutual fund?

The number one reason investors buy mutual funds is for diversification. A fund can hold as few as twenty stocks up to several hundred. These can include stocks, bonds as well as cash. If your investable assets are less than $50,000, mutual funds can be an ideal tool to diversify your portfolio. By investing, you are actually paying a professional manager or team of managers to oversee your investment. Since mutual fund companies have huge sums of money to invest, they may have the advantage of meeting directly with a company’s CEO and senior management before investing. This is definitely an advantage they have over an individual investor. If you’re busy living your life or don’t have the investment skills to research individual stocks, buying a mutual fund may be the perfect investment.

Need to sell fast, no problem!

Most investors view a mutual fund as a long-term investment. However, selling a mutual is as simple as selling a stock. If you place an order to buy or sell a mutual fund, you will receive a price at the close of the day; not at the exact time you call to place the order.

Mutual pitfalls

As with any security, mutual funds have their drawbacks. Although a manager is required to invest according to the mutual fund’s prospectus, you have no control over the individual stocks your manager buys or sells. If you have an objection to a certain stock such as your manager buying a tobacco stock, you have no recourse except of course to fire the manager and buy out your shares.

Hot one year, cold the next

With a mutual fund, your money is pooled with other investors. This can create a huge problem for you as well as the fund manager. The money can be put into a popular mutual fund that you own. This may require the fund manager to hold that money in cash or invest in other stocks outside of the fund’s intended purpose. This is usually the reason why a very successful fund may suffer in its performance the following year. Remember that your mutual fund company also cares about its bottom line. The more money they have in assets under management, the more fees they will bring to their business.

In addition to inflows, there are redemptions that your fund manager must take into account. In the event of a mass exodus from the fund in which you have invested, your fund manager must sell shares to pay the shareholders who sold the fund. In many cases, a mutual fund may hold cash to accommodate redemptions. This can cause you problems and affect your total return.

Taxes, taxes, taxes

A huge problem and perhaps the biggest downside of investing in a mutual fund is the tax liability you will have at the end of the year. If your mutual fund manager sold shares due to a shareholder buyout or simply sold shares because they believe a particular stock in the mutual fund’s portfolio has reached its full return potential , your fund realizes a capital gain. This capital gain is passed on to you and you must declare it as such in your tax return; even if you haven’t sold any shares. These gains must be distributed to all shareholders by the end of the year. Typically, your fund will report these gains in November or December. If you plan to invest in a mutual fund later in the year, you should call and ask when their distribution date will be so you don’t end up with a tax bill. Here’s a double whammy: if your fund made capital gains on certain stocks but still suffered a loss in NAV (net asset value), you may still be liable to pay tax on the capital gains generated at beginning of the year.

Note: This only applies to taxable accounts. If you are a mutual fund investor and it is held in a non-taxable account such as a 401k or an IRA, the above does not apply as you are not taxed until you have not withdrawn your money from your retirement funds.

Most fund managers don’t beat their benchmark

If you’re a bit worried, there’s more sobering news. Most fund managers don’t beat their unmanaged benchmarks. Standard and Poor’s researchers did a study in 2006 and found that only 38% of large-cap fund managers managed to beat the S&P 500 (the standard benchmark against which a large-cap fund manager would be judged) over a period of 3 years. Over a 5-year period, this number drops to 33%. The situation is much worse for small cap investors. Small cap fund managers lagged their benchmark by 24% over a 3-year period and only 21% beat the corresponding index over a 5-year period. This means that over a 5 year period you have a 67-79% chance of losing against an unmanaged index. In addition to the reason listed above, there is the human factor. Throughout market history, investors have sought the holy grail of investing. If the highest paid mutual fund managers haven’t found it after 100 years, chances are it doesn’t exist.

Fees and Commissions

As an investor, you actually pay a fee to a company to professionally invest your money for you. I can’t think of a single fund company that sends you an itemized invoice at the end of the year. However, by law, mutual fund companies must send out a prospectus detailing all the fees they charge. If you suffer from insomnia, their reading is highly recommended. Before investing, please call the fund company and consult your financial planner. Find out about your investment before sending them your hard-earned money. Remember that mutual funds collect their expense fees from you, regardless of their success.

Here is an overview of mutual fund fees and expenses:

1) Class A Share Fund Fees – These are commonly known as “loaded funds” and will charge a percentage of 1-6%. Over time, this can significantly reduce your total return

2) Class B Share Fund Fees – These funds are commonly known as “downstream loaded funds” and will charge a percentage when you sell your shares. Most downstream fund fees will dissipate if held for a number of years. For example, if you hold a fund with an exit load for 5 years, the mutual fund company may waive its fees.

3) Investment Management Fee – This money is used to cover the advertising costs and salaries needed to manage the fund.

Knowing the expense ratio of your fund is essential if you want to be successful in your investment career. The average expense ratio for a mutual fund is around 1.5%. This means that out of every $10,000 you invest, $150 is deducted for expenses, regardless of how your mutual fund performs.

Do you think the expenses are not important? Consider this fact: $100,000 invested over 25 years will turn into $684,500 if you achieve an 8% return. If you extract just 2% more over a 25-year period, you will have close to $1,100,000; a difference of $415,500. It could be the difference between sipping mojitos on the beach and having to work a host job at Walmart during your “golden years.” Invest wisely and consult a financial advisor. Your future may depend on it.

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