Myth Dispelled:  Mutual funds are useful

So, is this statement true?  Are mutual funds useful?  The answer is *yes*, they are useful.  But with a big if.  Mutual funds are useful IF you are ill-informed, not too bright and generally lazy.  

Now as the mutual fund industry in the US alone is greater than $10 trillion dollars in size (according to Investopedia), my claim is not going to be popular with many who work in what is a huge industry.  That’s ok, remember, I’m trying to help folks on Main Street, not the sharks on Wall Street

The good news is that if you are reading this, most likely none of these negative adjectives apply to you.  The fact that you are even reading this shows you are inquisitive and seeking to better your financial situation.  I can work with that!

So, back to mutual funds – why, then, are they worthless to people who want to take control of their financial future?  Before we get to that I’d like to up the stakes a bit.  Mutual funds are far, far worse than useless.  They are value destructive.  How so?  A double-edged sword of lousy performance plus fees.  Can you imagine anything so ridiculous of paying someone to deliver to you below market returns?

The fees you pay a mutual fund provider come in many forms, including:

  • brokerage and/or insurance commissions (called front-end of back-end loads, these costs can be up to 5% of your initial investment amount).  Granted this particular fee has garnered so much negative focus in the past that a majority of mutual funds are now ‘no-load’, so they don’t charge this fee.  However, some load funds are still out there.
  • There are ‘12b-1’ fees.  According to investopedia, 12b-1 fees are ‘an annual marketing or distribution fee on a mutual fund. The 12b-1 fee is considered an operational expense and, as such, is included in a fund's expense ratio. It is generally between 0.25-1% (the maximum allowed) of a fund's net assets. The fee gets its name from a section in the Investment Company Act of 1940.’ 
  • In addition to loads and 12b-1 fees, funds charge annual management and administrative fees.  Average management fees are in excess of 1%.  Each and every year.

So, let’s take out our calculators.  Let’s say that your mutual fund returned 10% in a given year.  If you had paid a load of 3% and 12b-1 fees of 0.5% and a management fee of 1%, then your 10% gross return would yield only 5.5% to you.  Meaning you’ve lost almost half of the returns in fees.  Even a no-load fund (or year 2 of the front-loaded fund) would still see you paying 15% of your profits to a fund manager - who most likely underperformed the market anyway.  This is craziness to the extreme.  And just like compounding of returns provides awesome power to you over the long term, this corrosive annual fees cause mass destruction to your returns if measured over a very long time period.

In his now classic book “Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor”, John Bogle, founder of the Vanguard Group, clearly shows how fees over the long term absolutely crush your net return.  You can find on  www.bogleheads.org the below chart which says it all:

There are two investors, each investing $10,000 in funds that grow 8% per year over a 30-year timeframe.

The low-cost investor pays 0.2% per year, meaning her net return per annum is 7.8%.  Over 30 years this results in a balance of $95,184 at the end of the period.

The high-cost investor pays an initial 5.75% in front-loaded fees, management expenses of 2% per annum and 0.25% 12b-1 fees.  So, right off the bat the initial investment is $9,425, not $10,000, due to the front-load fee.  Then each year, for 30 years, the net return is 5.75% due to the annual fees.  The balance at the end of 30 years?  About $50,000.

In other words over a 30 year period, mutual fund fees have eaten up nearly ½ of the high-cost investor’s returns.

If this doesn’t convince everyone reading this that mutual funds are value destroying, I’m not sure what will.  Layer in that less than 50% of actively managed funds (‘actively managed’ translates into funds charger higher than average fees) outperform the general stock market – I’ve even seen percentages as high as 90% over time that underperform the stock market – and it is clear that this industry exists to provide a nice tidy income to portfolio managers...at your expense.  

But of course you’re not supposed to know this…and the mutual fund industry spends tens of millions per year on fancy marketing programs to confuse and continue to entice money from your wallet.  

But now you do know...

› Mutual Funds
Bloomberg Businessweek

Myths Dispelled

Hot off the press!

  • Check out the NITK Weekly Journal here!
  • The NITK blog here
 Subscribe in a reader Subscribe in Bloglines

The Water Cooler

  • Click here to comment, suggest, even rant (!)
Google