Just as surgeons don't operate on themselves, wealthy people usually do not invest their own money. They have investment professionals manage their money for them.
In the next three bloga, we will discuss three types of professional money management and the differences between each. We will look at mutual funds, exchange traded funds and separately managed accounts, and the pros and cons of each.
There are many reasons why people select Mutual Funds in their own portfolios. Here are some of the most common reasons:
Mutual funds are suitable for the small investor because most accept small investment amounts, typically $2500 or less. Secondly, mutual funds offer liquidity with the ability to add or withdraw from your account at the end of any day. Additionally, the money is invested by an individual or team of individuals who are typically experienced investors, have a tested investing methodology, and have typically earned the Chartered Financial Analyst credential. This is a rigorous program of study, far more comprehensive than the exams a financial advisor or investment advisor must pass. So far, mutual funds appear to be an easy investment for any type of investor.
Maybe most important is diversification. Mutual funds may have from 30 to 500 different stocks in the fund thereby diversifying your money and potentially reducing risk to your principal. Should a couple of companies in the mutual fund do exceptionally poorly; the poor performers will not have a large impact on a big portfolio (note that diversification does not ensure a profit or guarantee against loss.) However, there are investors who would prefer not to use mutual funds as explained under the disadvantages section.
Fees: One of the often cited complaints about mutual funds is that of heavy fees. A summary of costs from various research studies calculated the average cost of owning a domestic equity fund at 3.17% annually in a non-taxable account. This does not include the cost of any front end or back end cost, redemption fees or 12b-1 fees2. A similar study by the SEC concluded that average fees were lower.3
Turnover and Taxes: Closely related to the issue of high fees is the issue of portfolio turnover and income taxes. (Please consult with a tax advisor as the information below is a general discussion). The turnover rate (frequency of purchases and sales) in a fund is not necessarily a bad thing but it does increase your tax bill if the fund is selling stocks with lots of short-term gains. Additionally, turnovers cost you money. If turnover does hurt a fund’s return, wouldn’t there be a correlation between a fund’s turnover rate and its after-tax return? Indeed there is!4
To optimize your mutual fund returns, or any investment returns, know the effect that taxes can have on what actually ends up in your pocket. Mutual funds that trade quickly in and out of stocks can have what is known as “high turnover.” While selling a stock that has moved up in price does lock in a profit for the fund, this is a profit for which taxes have to be paid. Turnover in a fund creates taxable capital gains, which are paid by the mutual fund shareholders.
The SEC requires all mutual funds to show both their before- and after-tax returns. The differences between what a fund is reportedly earning, and what a fund is earning after the investor pays taxes on the dividends and capital gains, can be tangible. If you plan to hold mutual funds in a taxable account, please check out these historical returns in the mutual fund prospectus to see what kind of taxes you might be likely to incur.
If you would like to know if your funds have high turnover and resulting high tax impact, please call for a free analysis on the funds you own. Next we have the issue of style drift.
Style Drift: Included in this topic of the fund-holding securities, what you may not want to own is the issue of style drift. For example, one might invest in a value fund which focuses on large “blue chip” companies selling at modest price-earnings ratios. But the fund manager may get tempted by the fast increase in Internet stocks and start allocating the fund’s money into these investments. You can avoid this problem of style drift by using funds that can never vary from their stated style in the prospectus.
Derivatives: Did you know some funds might borrow money to buy securities? Are you comfortable knowing that these funds may borrow money (in an effort to buy more stocks and enjoy gains), which could magnify losses if the market falls? Do you know if your fund uses volatile derivatives in order to boost returns? Derivatives are financial instruments, whose up and down price movements are based on the movements of an underlying security, such as a stock or bond. However, the derivative’s volatility is usually greater. If the stock moves 10% in value, the derivative could move even more. These issues are mentioned in your fund’s prospectus, but you may not know that your fund can be volatile until your fund’s semi-annual report. The use of leverage by mutual funds can significantly increase a fund’s volatility, so low-risk investors may want to avoid funds that trade derivatives.
Trading Limitations: Note that unlike a stock, you cannot buy or sell open-end fund shares in the middle of the trading day. While the once-per-day trading limitation may seem fine to you, more active traders desire to trade in the middle of the day and also to sell short to capitalize on market movements. While we will not discuss short-selling in this pamphlet, mutual funds cannot be sold short and there are no puts or calls on mutual fund shares.
Commingling: Last, is the potentially negative issue that your money is commingled with the money of other investors. When the market declines, if other investors in the mutual fund get nervous and take their money out of the fund, this forces the fund manager to sell securities in the fund. The sale is necessary to get the cash to send to the fund investors. So while you may view a decline as an opportunity to buy, your fund manager cannot do so as he is forced to sell to meet redemptions of the nervous investors.
2 The Real Cost of Owning a Mutual Fund, Forbes 4/4/11 http://www.forbes.com/2011/04/04/real-cost-mutual-fund-taxes-fees-retirement-bernicke.html
3 http://www.sec.gov/news/studies/feestudy.htm. Sites visited 12/20/19.
4 "Taxes are one of the most significant costs of investing in mutual funds through taxable accounts... Recent estimates suggest that more than two and one-half percentage points of the average stock fund's total return is lost each year to taxes." SEC website http://www.sec.gov/rules/final/33-7941.htm. Visited 12/20/19