The Pros and Cons of Investing in Mutual Funds

Although working with a financial advisor who invests in mutual funds may seem like a great way to “set it and forget it,” most investors fail to realize the truth about what these investments are costing them in fees that typically fly under the radar. The reality is that holders of mutual funds are experiencing costs amounting to multiples of what is apparent to them. If these invisible costs were taken into account, many would see investing in mutual funds in a different light.

The expense ratio leaves much to be desired

The advantages of investing in a mutual fund are many. Mutual funds are offered by SEC-registered investment companies that are heavily regulated. The manager’s track record is clearly disclosed, and many funds offer track records of ten years or more. The performance is audited and subject to high regulatory scrutiny. By pooling assets together with the other investors in the fund, the owner of a smaller account gets access to higher-quality, institutional-caliber money management than he or she would be able to gain investing directly. 

With hundreds of mutual funds out there, how does an investor pick the right one? Evaluating a mutual fund on management fee alone can leave some pretty hefty costs out of the equation. The expense ratio compares the management fee (what the portfolio management company gets paid for operating the fund on behalf of the shareholders) versus the assets in the fund. Expense ratios are disclosed, by SEC law, in the fund’s prospectus.

Trading and management fees

As they are deducted from the fund’s net asset value, trading and management fees have the potential to have a significant impact on a mutual fund’s performance and reduce returns to the shareholders. Mutual funds are actively managed.

Mutual funds have management fees that are disclosed and trading costs that are not disclosed. In one study by Morningstar, the average expense ratio for US stock mutual funds was 1.25%. To the Financial Analysts Journal, the average trading cost is 1.44% with small cap mutual funds paying, on average, 3.17% per year. On expense ratio and trading costs alone, the average mutual fund is costing the investor nearly 2.7%.

The reality is that on top of the 2.7%, there are other fees lurking behind the scenes, namely the financial-advisor fee. Investors working with a financial advisor who allocates money to mutual funds will pay the financial advisor’s management fee of about 1% on top of the fees charged by the mutual fund. This may drive up expenses considerably and significantly reduce net return to the investor.

Tax inefficiencies

Many investors do not consider the tax expense of owning shares in a mutual fund instead of holding the stock positions directly. It is common for investors to experience losses in portfolio value due to swings in investment value that they did not directly benefit from.

Here’s an example:

Let’s say that you bought into a mutual fund that holds a position in XYZ stock, which is currently trading at $30/share. The next day, the stock drops to $20/share, leading the portfolio manager to get out of the position. You’ve essentially taken a $10/share loss. But that’s not where it ends. If the mutual fund bought into the position previous to you at a price lower than $20/share, you also pay your share of the fund’s capital gains tax. In essence, you are paying for other people’s gains, not yours.

To continue with the previous example, let’s say the fund bought the stock at $5/share. In addition to the loss of principal, you also are on the hook to pay out of pocket for a $15/share gain. You’ll see this on the annual 1099 form that the fund sends you at the end of the year.

High turnover also drives up the tax bill if the positions are liquidated at a gain. According to Morningstar, the average mutual fund in the United States has a turnover ratio of more than 100%, meaning the entire portfolio is liquidated and replaced at least once over a 12-month period.

The bottom line for investors

Although the advantages are several, investing through an investment advisor who directs money into mutual funds as opposed to holding the positions outright can have quite a substantial impact on portfolios.

In this scenario, let’s say you shell out 1 to 1.5% in advisor fees. This middleman then invests in a commingled vehicle such as a mutual fund or even life insurance or annuity vehicle, products that typically charge fees on top of that. Investors should also be aware that many financial advisors receive kickbacks or sales-load incentives for directing client money into certain mutual funds. Very often sub-par performers, these funds attract assets by luring advisors in through financial rewards. The bottom line for investors can be fees averaging from 3.7%, plus a hefty tax bill.

Pros of investing in mutual funds:

  • SEC registered and heavily regulated
  • Transparent track record
  • Smaller investors gain access to institutional-caliber money management

Cons of investing in mutual funds:

  • Trading costs
  • Tax inefficiencies
  • High turnover
  • High fees

Investors should rethink the choice to use an advisor who invests in mutual funds, as they carry with them a variety of implicit and explicit costs. 

For more information about how to decipher a Form ADV, visit Dash Investments or email me at dash@dashinvestments.com.

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