Disadvantages of Mutual Funds Every Investor Should Know

If I had a nickel for every time I argued with people about mutual funds’ risks, I’d have a whole lot of nickels. You know what I’d do with those nickels? I’d invest them in something other than a mutual fund.

I’ve made these investments in the past. I’ve worked with people who bought into mutual funds and saw a solid return. Believe me, I’ve heard all the arguments in support of this investing strategy. While plenty of success stories exist, the downside with mutual funds is bigger than most people think. I’ll explain why that is, but first…

What About Pros?

When people sell you on the benefits of mutual funds, they’re not outwardly lying to you. These accounts offer plenty of diversification, meaning that mutual funds’ risks are often spread over multiple economic sectors. You will have someone with years of market experience in your corner, helping make complex decisions regarding your portfolio. You can certainly have input in the disbursement of your capital and the companies that make up your fund.

Mutual funds also come in a variety of shapes and sizes, which makes them an intriguing purchase. Fill your portfolio with standard assets, or get crafty and look into funds that only deal in precious metals or other resources. Mutual funds cater to all sorts of investment strategies, from standard 401(k)s to short-term savings accounts. Brokers have no trouble finding funds that align with an individual’s specific investment outlook.

Sounds good, right? Versatility, flexibility,simplicity. You’d be a fool to want anything less from your investing account. Unless, of course, there was a price to be paid for all these conveniences. Could it be that, on the flipside of the benefits, you’re faced with some features that hurt your investment more than they help? For those of you just joining us, the answer is a resounding “yes.”

Fees, Please

Many, many funds are sold under the guise that you don’t pay a transaction fee. But do you really believe that’s the case? Do you think your account manager is the only financial agent in the world who doesn’t collect fees for his or her services?

If you it’s not in the form of transaction fees, you’re definitely getting hit in multiple other areas. The most common include:

●       Annual Expense Ratio

●       Front-end Load Fees

●       Back-end Load Fees

The annual charges on the expense ratio can be a real doozy. This charge covers the various services that are theoretically provided during the year, such as compliance, management and marketing. Even if the fee is just one percent, that gets applied to the entire balance of your account. Got $200,000 tied up in your mutual fund? Expect to see a lot of money taken in expense fees. The percentage is typically so small that this cost doesn’t raise many red flags in the early going. It’s not until a couple years in that you start to see a lot of your returns heading into pockets other than your own.

If the expense ratio hasn’t scared you off, don’t worry! There’s still time for you to lose plenty of money in the form of load fees, which are applied when you first invest or when it’s time to cash out. This means a $5,000 investment with an upfront charge of two percent reduces your investment to $4,900, or the sale of $5,000 worth of shares only nets you $4,900. Those numbers might not cause you to panic, but your retirement account will hopefully grow beyond $5,000. Once you’re buying and selling $500,000 worth of shares, two percent is no longer just a drop in the bucket.

What’s even more depressing is that you might have to pay multiple fees to multiple agents. Some of these expenses don’t go to your broker, and are instead collected by companies that regulate mutual funds. Even if your manager is very clear and honest about service fees, there’s still a good chance that more expenses are waiting in the wings. These semi-sneaky fees are some of the main disadvantages of mutual funds.

Mutual funds are very popular, but you need to think about why that is. Is it because clients get amazing returns, or might it be that the people selling mutual funds get to pad their own wallets? When you start adding up the various fees, and looking at all the people taking money out of your account, it’s obvious why fund managers tend to push these products so aggressively.

Nice Account. What’s in It?

Not to toot my own horn, but I win a lot of disputes with this simple question: “What exactly is in your mutual fund?” 99 out of 100 times, the investor has no idea what their money is doing. Personally, that sounds like a terrifying way to save for the future.

I understand that many people plan for retirement without much knowledge of how the market works. This is a better practice than not saving at all or even risking everything on exotic, bad investments, but there needs to be at least a little effort. Don’t you want to feel confident about your financial stake in the market? Don’t you want to know why your account is over or underperforming?

Unfortunately, lots of fund managers benefit from keeping their clients in the dark. If you pay a small fee for every transaction, you better believe your broker is looking to buy and sell frequently. You aren’t going to be consulted before these moves are made, as having a professional make decisions on your behalf is just one of the many “benefits” you’re paying for in that annual expense.

In addition to losing money on fees, excessive trading also hurts the overall performance of your account. Over diversification is a real issue for mutual fund holders, as people end up with hundreds of different positions within their portfolios. While there’s no set number of companies that you should hold, most experts don’t see much merit in diversifying beyond 20 different options. Any more than that doesn’t significantly reduce a mutual fund’s risk profile.

What happens when you diversify excessively? At a certain point, your risk starts to mitigate your returns. It’s like walking up to a roulette table and putting money on 33 out of 36 numbers. Your odds of hitting a winner are great, but you’re guaranteed to pick a lot of losers as well. People often claim bigger is better with mutual funds, but that isn’t the case. At a certain point, bigger starts to mean badder.

Another significant problem with maintaining too many positions is how chaotic your accounts become. It would take a computer-like brain to adequately manage hundreds of holdings in one account. You can’t expect your fund manager to monitor hundreds of different companies, which means he or she probably isn’t always making moves at opportune moments. If you ever hear brokers pushing for bigger mutual funds, ask how they effectively monitor multiple clients who own hundred and hundreds of positions. I’m confident they won’t have a satisfactory answer.

When you don’t know what’s in your account, it’s impossible to understand the moves your account manager is making and what it all means for your future. It’s a better choice to keep the power in your own hands, and to invest in companies you like and industries you trust. Is it possible to accomplish that with a mutual fund? Sure. Will it be difficult and involve arguing with the fund manager? Quite likely.

Them’s the Rules

Rules and regulations usually come to pass out of necessity. Government officials and business owners establish guidelines as a means of looking out for citizens and consumers. Then, almost without fail, problems start to arise. If you’re searching for examples of rules that don’t actually help the consumer, mutual funds are a great place to start.

As a means of maintaining order and oversight, your fund manager cannot hold onto cash for an extended period. Whenever you put funds into your account, that money will almost immediately be used to acquire new positions. While that is the purpose of putting money into a fund, making immediate moves isn’t always in your best interest. There’s a definite risk of managers being forced to make lackluster or even bad investments. This system, and the way these funds are structured, means your dollars have to go toward either a small-growth or a large-growth stock, depending on the type of account. At any given time, the market can be rather hostile toward either of these options, making an immediate purchase a bad idea.

There’s also the issue of forced redemption, which most people haven’t heard of and wouldn’t recognize if it hit them in the face. When the market gets fidgety and investors start to bail on a particular fund, there may be an unexpected rush on redemptions. The result is fund managers scrambling to raise redemption capital, and that often means selling your shares. Even if it’s in your best interest to hold a position, your broker might not have that option. This usually happens during a market correction when you want to be weathering the storm, not selling shares and taking a loss.

Generally speaking, these rules don’t cause investors to lose their shirts. If that was the case, mutual funds wouldn’t get all this love from brokers and consumers. However, these mutual fund risks are not uncommon and are never explained to investors. If you don’t stay on top of your account management, you could be making mediocre moves without even knowing it.

Staying the (Bad) Course

Mutual fund managers are not evil people. They are, however, people who want to keep their jobs and continue supporting their families. While that’s a very admirable characteristic, it’s also part of the reason you might not get the most out of your account.

Most mutual funds are sold through large firms, and the majority of accounts contain a lot of the same stocks. This is because managers don’t benefit from creative, outside-the-box thinking. While an unorthodox purchase might be the best thing for your portfolio, there’s no good reason for your account manager to take that risk.

Risk isn’t a good stand-alone investment strategy, but it’s an important component of diversification. You diversify your mutual fund so if one stock slumps, the others will pick it up. Bad investments are balanced out by good performers. If everyone of your positions avoids risk entirely, you might not own anything that will help you outperform the market. Your money isn’t going to disappear, but you’ll almost certainly see other investors pass you by. That’s not a good strategy for you, but it’s exactly how account managers stay out of hot water.

You don’t start a retirement account to pay someone else’s bills. If you’re investing in a mutual fund that’s delivering mediocre returns because the manager has no real incentive to work hard for you, it’s time to move your money.

Tax Trouble

How your retirement account gets taxed is important. This is a matter you need to think about ahead of time so you can choose a plan that makes sense for your income, lifestyle and savings goals. For these reasons, the disadvantages of mutual funds are probably going to let you down.

What causes mutual funds to be so bad on the tax front is a strange rule that doesn’t really apply anywhere else. When a company sells shares and gets taxed on that revenue, you have to pay the bill. Your fee comes by way of a capital gains distribution, spread among the various holders. Here’s where it gets ugly: that fee is shared equally, no matter how long you’ve held the stock in question. Whether you’ve had that position for five years and seen steady returns, or you just bought in six months ago and have yet to see a dime, you pay the same annual fee as the other people invested in that fund.

This system isn’t particularly fair, and it can cost you money for no fault of your own. To me, that’s just nuts. You’re giving money to a professional investor, losing substantial amounts of cash in the form of service fees, and you stand to pay a tax penalty before you enjoy any of the gains. Why not save some time and just flush the money down the toilet?

What’s the Alternative?

Mutual funds are easy. You might not find an easier way to put your money to work in the stock market, and that’s why the appeal is so vast. And, when all is said and done, mutual funds’ risks of serious losses are minor. You know what else is appealing, simple and predictable? French fries. They’re very easy to eat, always delicious and you can find them for sale almost everywhere. Fortunately, you know that eating french fries all the time is bad for you, even though it’s very easy to do.

Just as you worked hard to earn your money, you have to put in a little effort to grow it. If it were easy to get 10 percent returns on every investment, don’t you think more people would be striking it rich? There are plenty of stories of people having success with mutual funds, but it shouldn’t surprise you that those stories are mostly told by brokers. A product that brings in tons of money will always get glowing reviews from those reaping the benefits, and the fact is that brokers, fund managers, and consumers don’t always have identical interests. This disconnect is one of the hidden disadvantages of mutual funds.

Instead of taking the easy route and hamstringing your return potential, I urge you to take control of your investments. You may need advice, and there are plenty of advisors out there who aren’t going to ding you for every transaction or lead you down the road of over diversification. Find out what markets are performing well, read up on the industries that interest you, and spend your dollars accordingly.

I always have to remind people that mutual funds aren’t reinventing the wheel. You’re still buying and selling stocks,there are just a handful of people collecting a percentage of your money throughout the process. If you’re wondering what my angle is, I’m not the only wealth manager opposed to this type of investing. In fact, most investors who have struck it rich through the stock market have done it through individual shares, not mutual funds. It’s not just that these people are savants with a knack for picking a company that’s about to explode; smart investors know that every dollar matters, and an account that costs you an annual gains fee and four percent on the front end is not an efficient way to spend.

You should be personally invested in your investing. When you tie your money up in a mutual fund, you pass the buck (literally) to a third party and become much less proactive. Not only that – you lose money as a result of losing control. I know taking the easy route is enticing, but when it comes to your money and your future, you have to be willing to work for it.

Make it happen!

Taylor & Megan Kovar

The Money Couple