This Investment Will Sink Your Portfolio

Your portfolio is like a brand-new boat that, over time, will inevitably develop holes and rust. The bad news is that your boat can sink, and along with it goes your life savings. The good news is that those holes can be avoided.

How? Get out of mutual funds right now. Why? Because they're a terrible investment.

I know that sounds harsh, but keep reading, and I promise I'll offer an investing strategy that is much better than the one you're probably pursuing right now.

Let me explain
It's been well-documented that mutual funds have underperformed the general market over long periods of time. In fact, actively managed mutual funds typically return 1.5 to 2 percentage points less than the overall market. Many people are aware of this but continue to throw their money down the drain. Fortunately, Morningstar recently released a report that can add some much-needed clarity to the topic.

Morningstar tracks funds based on past performance and volatility and then assigns them a star rating, indicating which funds are superior. However, it just announced that lower costs and fees were a much better indicator of future success than its own rating system. Specifically, it found that between 2005 and 2010, in every single asset class, the least expensive funds produced higher returns than the most expensive funds.

The main reason? Funds charge management fees, marketing fees, and because they have extremely high turnover, they have higher trading fees as well. These expenses add up and slowly eat away at your wealth. Bill Houck, a certified financial planner at Modera Wealth Management, puts it best: "Study after study has shown that most managers can't justify the cost of the fund over time."

Still not convinced? Take a look at your average mutual fund -- the expense ratio (how much you pay to hold that fund per year) is probably at least 1%. That modest-looking fee can strip away more than 40% of your savings over a 60-year period. This type of investment will absolutely sink your portfolio, period.

Take two simple steps
First, if you're completely tied to the idea of investing in mutual funds, then avoid ones with high costs and invest only in funds that have expense ratios of less than 0.75%. Broad exchange-traded funds can easily give you the market exposure you need -- for instance, the Vanguard Total Stock Market ETF (FUND: VTI  ) provides wide stock coverage and has a paltry expense ratio of 0.07%. Internationally, take a look at the Schwab Emerging Markets Equity ETF (FUND: SCHE  ) , which has a low fee of 0.25%.

I understand that there are plenty of investors who don't want to just sail along with the indexes -- you want to beat the market, not follow it! That's great, but what you need to do is invest in individual stocks instead of funds. Think this is too time-consuming, that all the volatility may keep you up at night, or that you don't trust particular companies? Nonsense!

Let's first look at one example that can easily exemplify the entire strategy of investing in funds versus their cheaper ETF counterparts. Say you're a value investor interested in finding some great stocks at cheap prices. Consider two options, an actively managed fund versus a low-cost ETF:

 

Price to Earnings

Price to Book

Dividend Yield

Expense Ratio

Oak Value Fund (FUND: OAKVX  )

14.3

2.3

2.43%

1.57%

Vanguard Value ETF (FUND: VTV  )

11.5

1.4

3.10%

0.14%

Source: Morningstar; figures are for stocks within each fund's portfolio.

Not that I have anything against the Oak Value Fund, but why would an investor put hard-earned dollars there when all the studies in the world have pointed to low fees as the best gauge of future performance? Additionally, the ETF has picked stocks with lower P/E and P/B ratios, and its portfolio also pays a higher dividend yield!

Let's take this one step further. You tell me that the Oak Value Fund has a chance at beating the market, and you're willing to pay up for that opportunity. As an avid investor, I understand the need and the urge to outperform an index or a passively managed ETF. Well then, I say, just invest in the individual components that make up the fund and avoid those high costs! Let's take a look at how that may actually work by listing seven of the biggest stocks in the Vanguard Value ETF and compare them to the traits of the Oak Value Fund.

 

Price to Earnings

Price to Book

Dividend Yield

Oak Value Fund (portfolio aggregate)

14.3

2.3

2.43%

ExxonMobil (NYSE: XOM  )

11.5

2.2

2.9%

JPMorgan Chase (NYSE: JPM  )

11.1

0.9

0.5%

Chevron (NYSE: CVX  )

9.1

1.6

3.7%

Merck (NYSE: MRK  )

8.9

1.9

4.3%

AT&T (NYSE: T  )

12.4

1.5

6.3%

Altria Group (NYSE: MO  )

13.4

10.3

6.2%

Bristol-Myers Squibb (NYSE: BMY  )

4.6

2.9

4.9%

7-STOCK AVERAGE

10.1

3.0

4.11%

Sources: Morningstar; Yahoo! Finance as of Aug. 14.

Simply put, you can buy these individual stocks at a cheaper price and obtain a higher dividend yield than if you bought the actively managed fund.

The Foolish bottom line
If you're a beginning investor or even an old sage, there's no better advice than to avoid high fees that never end up justifying themselves. Give yourself the best opportunity to obtain and build wealth over the long run by picking up cheap, quality stocks -- ones that pay dividends are just another reason to be content with your investment strategy. I guarantee that this philosophy is much better than sitting back and hoping for the best with your current mutual funds.

Do you disagree with me? Would you rather own an actively managed fund as opposed to seven excellent stocks? Let me hear it in the comments below!

Jordan DiPietro owns shares of the Vanguard Total Stock Market ETF. Chevron is a Motley Fool Income Investor selection. The Fool owns shares of Altria Group and ExxonMobil. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (88)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 16, 2010, at 1:09 PM, kalvinkuhn wrote:

    Overall, a good article. The next time you write an article on this subject, how about running two scenarios - one with low cost index funds and another with funds averaging 1-1.5% fees? You stated that the fees would eat away 40%. I wish you would have expanded this insight a little more.

  • Report this Comment On August 16, 2010, at 3:14 PM, TMFPhillyDot wrote:

    @kalvinkuhn,

    Thanks for the comment. Your suggestion would definitely make for an interesting side-by-side comparison. Will certainly keep it in mind.

    Foolishly,

    Jordan (TMFPhillyDot)

  • Report this Comment On August 16, 2010, at 3:43 PM, FutureMonkey wrote:

    Actively managed mutual funds made a lot more sense in the 80's when majority of investors had little to know access to the kinds of information that professionals had, nor the ability to make trades without heavy broker involvement/fees. Even load mutual funds made the more sense than owning individual stocks for investors seeking diversification and expert money management with modest portfolios. I bought $2500 of Fidelity Contrafund in 1990 and benefited greatly. ETF's and Index funds are newer inventions and many money managers are not paid well to steer clients to ETFs or individual stocks. Somebody with time, knowledge, and ability to actively manage their own portfolio can easily mimic a diversified MPT type portfolio with multiple asset classes and rebalance quarterly, semi-annually, or annually by using ETFs with minimal costs, next to no research or understanding, and zero visits to a brokerage house and probably come close to equal or better performance than a frenitically traded actively managed fund. People can also get into trouble micromanaging their ETFs, ETNs, and cash positions and end up spending more on fees than any 1.5-2.0% in a mutual fund. If you are patient and not prone to panic/exhaltation then this is a smart way to go. If you flinch reflexively in response to the talking heads on CNN or the opinions of somebody tossing rubber toys at the camera, then stick to Mutual Funds, go into the other room and read a good book.

  • Report this Comment On August 16, 2010, at 3:57 PM, CPACAPitalist wrote:

    Mutual funds exploit individual investors who spend their life working away and putting the reccomended amount into their 401(k), not knowing what they are being charged and the other options available to them. If you want to take control of your financial future you will be way better off with some low cost ETFs to keep up with the market, and then doing some quality research and trying to pick some winning individual stocks along the way. Throwing your cash into the designated mutual funds in the company's 401(k) plan is doing yourself a disservice. I think that the company should also bear some responsibility to educate employees investing through their retirement plan.

  • Report this Comment On August 16, 2010, at 4:35 PM, JBivins wrote:

    Haven't Bogel and Graham been pointing these facts out to investors for a long time? I still believe, along with both of them, that no load, low cost, low turnover index funds are going to be the best way for the average America worker to save for retirement.

  • Report this Comment On August 16, 2010, at 5:02 PM, StockJockette wrote:

    Hmmm. This sounds like another fluffy piece of jouralism that contains a broad generalization leading the reader to the wrong conclusion: all actively managed mutual funds are bad because they cost too much.

    It also sounds like the old argument during often heard in the 90's that an investor would be better off in index funds rather than actively managed funds. This was before the advent of most ETFs. During the 90's, index funds became very popular because they generally outperformed more expensive funds. Of course, this was during the explosive market growth, but became not true during the next decade.

    Personally, I think compared performance is dependent upon the measuring dates historically. Certainly during a growth market, ETFs and lower cost index funds will generally outperform actively managed funds, but what about during a down market? The average annualized return of the S&P 500 index from 3/31/2000 to 3/31/2010 was

    -1.06% and ytd even worse. According to Morningstar, over 900 domestic stock funds beat that record. Vanguard's S&P500 Index fund with an enviable expense ratio of .18%, wasn't in the list that beat and, in fact, did worse! And those poor souls who had ETF Powershares did even worse at -6.18. Compared with Columbia's Dividend Income Fund, class C with a notorious 1.88% expense ratio, during the 2000's, I think an investor would have been very happy to have the Columbia fund, at an average positive 4.27% for 10 years according to Morningstar.

    It would be very difficult to compare an individual's stock portfolio with an actively managed fund because most investors would not be able to be as diversified. With less diversification, risk goes up and performance during a downturn, generally goes down. Also, it would be hard to do a comparison to an ETF portfolio because most ETFs were not around prior to 2000 (only 32 were traded) and only 26 of those beat the S&P 500 index during the last decade, and many of those were foreign sector funds. It would be hard to do an apples to apples comparison. The next decade will be more telling because we will have more to compare.

    While I believe cost is definitely an important factor, the old white paper study from 1990, published in the Journal for Financial Analysts is still more accurate--be diversified and rebalance. Most certainly, modern diversification would include ETFs and perhaps individual stocks, along with your favorite fund managers that doubled or better the S&P 500 Index record during the last decade. So, take the article for what its worth--a fluffy piece of journalism.

    (I do not own any of the positions mentioned.)

  • Report this Comment On August 16, 2010, at 9:07 PM, thunderboltnova wrote:

    I agree with his reasoning. Why pay for window dressing and for when people panic and sell their fund shares? What I would do is keep an eye out for good companies which go on sale and put a position on them. Then as more and more go on sale over time, keep buying. As long as the person keeps buying different companies in various sectors over time, they will be diversified. It doesn't have to be done overnight.

    It takes discipline and courage but if you have the fortitude, it can be done. The biggest problem is the investor himself since he is his own worse enemy. They buy after the market shoots up to the top and then sell when it looks very scary. The media should encourage investing during market sell offs and not tell people they're only catching a falling knife. They only scare the average investor with their doom and gloom.

  • Report this Comment On August 17, 2010, at 6:18 AM, Stonewashed wrote:

    Not that I disagree with this article, but TMF should really make up its mind. Their position about the pros and cons of mutual funds seems to change with the direction of the wind, to the point where they are actively promoting them on their site.

  • Report this Comment On August 17, 2010, at 9:11 AM, TMFPhillyDot wrote:

    @Stonewashed,

    I think that overall, TMF presents a fairly objective and diversified view of mutual funds. While some writers are more prone to advocate for funds, others are less so; however, overall, TMF champions investors to look for individual stocks. At the same time, we try to help investors who are seeking mutual funds to find the best ones. check out my fellow Fool's recent article for an example:

    http://www.fool.com/retirement/general/2010/08/05/low-barrie...

    Best,

    Jordan (TMFPhillyDot)

  • Report this Comment On August 17, 2010, at 12:48 PM, passivefool wrote:

    John Bogle's "The Relentless Rules of Humble Arithmetic" is easy to read and outlines the basic math that supports the assertion that fees can greatly diminish portfolio value over time....also, market-timing penalties (who does it consistently well over many decades?) and taxes can have an even greater negative impact on portfolio values over time. It's worth doing a Google search and taking 20 minutes to read Bogle's research.

  • Report this Comment On August 17, 2010, at 3:05 PM, TMFPhillyDot wrote:

    @passivefool,

    Thanks for the suggestion!

    Best,

    Jordan (TMFPhillyDot)

  • Report this Comment On August 17, 2010, at 8:55 PM, 1caflash wrote:

    I agree with Jordan. My financial advisor and I mutually manage the larger account and the tax-deferred IRA. I'm diversified and have cash to prudently add to dividend-paying stocks. CVX, MRK and Mo are in our portfolio. I threatened to leave his firm because mutual-fund-picking was not our main strength; we sold every fund I had May 2010. We Trust each other! In less than three months, my IRA is performing well. The larger account is used for liquidity when need be. Two smart people working as one team is so much better than depending on total strangers.

  • Report this Comment On August 24, 2010, at 11:43 AM, philkek wrote:

    Thanks MF for a good article and thoughtful Fool comments. Of the stock symbols listed I currently own MRK. I will investigate the fundamentals of the other stocks here before spending my money. Better Business Bureau advises all fools to investigate BEFORE you invest. Keep up the good work Fool on for profits.

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