I'll start this duel by conceding that mutual funds are a tremendous way for some people to build wealth. Unfortunately for fund investors, those people are generally the owners of the fund companies themselves. Consider the case of Legg Mason Value Trust
The concept behind mutual funds is great. After all, you get instant diversification and professional money management, which should let you put your portfolio on autopilot. Unfortunately, there is still no such thing as a free lunch. You pay dearly for that convenience. There are three major hurdles that funds have to clear, on top of the ordinary challenges involved in investing to beat the market. As tough as it is for individuals to beat the market, those challenges make it that much tougher for the funds.
Let me tackle them, one by one.
Size
The larger a fund gets, the larger each individual investment needs to be for it to have an impact on the fund's performance. This makes it extremely costly for funds to successfully and profitably move in and out of companies as their businesses change. For instance, Fidelity's Contrafund
If Genentech's business falters, it would be extremely costly and time-consuming for the fund to unwind its position. Individual investors, with more reasonably sized holdings, can freely make changes as the need arises.
Time
In addition to the woes associated with their sizes, funds face another problem. Ultimately, they manage other people's money. Those other people can and do remove their cash, if the fund starts to slip. When investors cash out of a fund, the fund must sell more holdings to cover the redemptions. When combined with the size dilemma, that exacerbates the underperformance problems that led to the investors cashing out in the first place. That's a large reason why Fidelity's Magellan
Because they fear the vicious cycle of redemptions, funds focus on managing short-term volatility instead of focusing on long-run business strengths and risks. That worry can cost them serious long-term returns, sacrificed on the altar of price stability. I eventually sold my investment in Presidential Life
Fees
Of course, not only do funds' large size and short time horizons hamper their ability to beat the market, but there's also the direct bill involved. After all, fund investors are getting professional guidance, and that doesn't come cheap. Assuming a fund has a 1% expense ratio, that fund needs to outperform the market by that much just to break even. That may not sound like much, but if the market returns on average 10% a year, it's a 10th of your overall expected return.
If you must invest in funds, skip the headaches and go straight for the index. Vanguard's Total Stock Market
The Foolish bottom line
Mutual funds' size, time horizons, and cost structures force them to leap tremendous hurdles to beat their benchmarks. With structural problems like that, why bother even handing them your money to try?
Think you're done with the Duel? You're not! Go back and read the other three arguments, and then vote for a winner.
At the time of publication, Fool contributor Chuck Saletta owned none of the companies or funds mentioned in this article. The Fool has a disclosure policy.