Why Active Mutual Funds Destroy Value

Yes, that headline may be provocative, but is it true? Do mutual funds really destroy value? Or, from a different angle, are mutual funds useful? The answer is yes, they are useful -- for lining the pockets of the fund managers. For you, the investor, much better results can be achieved by taking control of your financial future.

Given that the mutual fund industry in the U.S. alone is greater than $10 trillion dollars in size, my claim won't be popular with the many insiders in that massive industry. That's OK, as I aim to help folks on Main Street, not the sharks on Wall Street, where I began my career.

The good news is that if you are reading this, you can take control of your financial future starting now.  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 are they worthless -- indeed, even value-destroying -- to people who want to take control of their financial future? It's the double whammy of lousy performance and fees. Can you imagine anything so ridiculous as paying someone to deliver below-market returns?

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

  • Brokerage and/or insurance commissions. Called "front-end" or "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.
  • 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."
  • 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 your mutual fund returned 10% in a given year. If you had paid a load of 3%, 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 to fees. Even a no-load fund (or a front-loaded fund in year two) 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 as compounding of returns provides awesome power to you over the long term (Einstein is rumored to have called compound interest the most powerful force in the universe), this corrosive annual fee causes mass destruction to your returns over a 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 absolutely crush your net return over the long term. Let's look at an example.

Imagine two investors, each investing $10,000 in funds that grow 8% per year over a 30-year time frame.

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.

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 amounts to $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.

Source: Bogleheads.org.

In other words, over a 30-year period, mutual-fund fees have eaten up nearly half 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 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 tidy income to portfolio managers at your expense. Want more evidence? Read about my personal experience with just this issue on New Investor Tool Kit.

But of course you're not supposed to know all of this -- and the mutual fund industry spends tens of millions per year on fancy marketing programs to confuse you and entice you to waste your hard-earned money.

But now you know. So what do you do?

Consider two alternatives to mutual funds: low-cost ETFs or, better yet, dividend-paying stocks with a low-cost dividend-reinvestment program. Some of my favorites include stalwarts like Coca-Cola, 3M, IBM, and Cisco.

So get out there and take control of your financial future. With all of the free information and tools out there on the Internet, there really is no other better choice you can make.

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