Investors often include mutual funds in their retirement portfolios because mutual funds provide a quick and easy way to invest across a large number of companies, even if one is investing only a small amount. The problem, however, is that mutual funds have some significant drawbacks, including these four "secrets" that our top Motley Fool contributors expose.
One thing that traditional mutual fund managers really don't want their shareholders to know is that their funds have a big tax disadvantage compared to their exchange-traded fund counterparts. They often create considerable tax liability even for those investors who never sell their shares.
Each year, mutual funds are required to take any capital gains they generate from selling their investment holdings and pass them through to shareholders in the form of taxable capital gains distributions. Unless you own your mutual fund shares in a tax-deferred account like an IRA, you have to include those capital gains on your tax return as taxable income -- even if you reinvested the distribution straight back into the mutual fund and never saw a penny of that money yourself.
ETFs are subject to the same rules; but because most ETFs use passive investment strategies that follow indexes, they don't have as much buying and selling as regular mutual funds. Moreover, even when shareholders want to sell off substantial amounts of ETF holdings, the ETF can meet large redemption requests by giving selling shareholders blocks of stock in the ETF's holdings, rather than selling the holdings themselves and generating capital gains. Over time, the tax disadvantage from mutual funds can cost you substantial lost after-tax returns.
One thing that mutual fund managers don't want you to know -- and they can rest assured that many people don't know -- is that very often, you're paying more than you need to in fees. Sometimes a lot more.
For starters, there are sales loads charged for many funds, and they can be as high as 5.75%. If you plunk $3,000 into a fund with such a fee, you'll immediately be charged $172.50. That's a shame, since there are many "no-load" funds out there.
Even among no-load funds, though, there is a wide range of annual fees (also called "expense ratios") that you'll encounter. A bit of good news is that mutual fund fees have been dropping in recent years. The average stock fund, for example, has seen its expense ratio drop from 1.68% in 2003 to 1.37% in 2013, and investors are increasingly favoring low-cost funds. That's good. Keep those numbers in mind, though, when you're comparing funds. A fund might look great and have a solid performance track record. But if it's charging you 1.8% per year, know that you're paying more than you have to, and its performance (which can't be predicted or guaranteed) had better make up for that premium fee. Remember that 1.37% is the average, meaning that you'll find plenty of lower fees -- especially in larger funds, because they can spread their costs over a lot more assets.
If you favor index funds, as many investors do (and should!), then know that you should expect far lower fees. Running across, say, an S&P 500 index fund with an expense ratio of 0.48% might look good compared with the average stock fund's fee, but index funds sport average fees of close to 0.13%. Fees matter a lot. As our friends at the Securities and Exchange Commission have explained: "[I]f you invested $10,000 in a fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858."
One thing mutual fund managers don't want you to know is that many so-called "active" mutual funds are basically index funds in disguise. This is an important distinction -- an index fund might cost you 0.1% a year in charges, whereas an active fund will include anywhere from 1%-2% in charges a year. So you could be paying 10-20 times the amount in fees that you should be, and that's coming directly out of your retirement savings.
A pair of studies conducted in 2009 and 2013 show that a growing number of funds have become "closet indexers" -- that is, actively managed funds that are essentially index funds in disguise. According to the studies, which consider 20 years’ worth of fund data, by 2009 index funds had gone from composing less than 5% to around 20% of all mutual fund assets. However, during that time frame, there was also an explosion in closet indexers; they went from making up 10% to composing nearly 30% of all funds.
Through closet indexing, managers can make sure that their results won’t stray far from the performance of a respective index. Also, they can make certain that they continue collecting their high fees when their results, whether they outperform or underperform, aren't that much different from the index’s. And that is something they’d rather you didn't know.
My colleagues all make very great points about the huge impact of seemingly small fees, and how most managed funds are little more than shadows of the benchmark index they rate against. These alone are good reasons to avoid actively managed funds. However, some of you may read this and think: "The best active funds are always the best, right? Can't I just invest in the top performers each year?"
The reality is -- and mutual fund managers certainly don't want investors to know this -- that's almost a surefire way to underperform the market.
According to S&P Dow Jones Indices' Persistence Scorecard, only 9.8% of the top-performing funds as of September 2012 were in the top quartile through September 2014. Let me emphasize that: More than 90% of the top-performing funds had fallen out of the top quartile within two years. Stretch out the time frame, and the likelihood of one remaining a top performer gets even worse. From the Persistence Scorecard (emphasis mine): "An inverse relationship exists between the measurement time horizon and the ability of top-performing funds to maintain their status. It is worth noting that less than 1% of large- and mid-cap funds managed to remain in the top quartile at the end of the five-year measurement period."
Active funds just underperform. According to S&P's SPIVA Scorecard 60%, 86%, and 74% of U.S. active funds were outperformed by their benchmarks over the past one-, three-, and five-year periods.
What more evidence do you need? Invest in the low-cost index fund, or invest in a basket of great stocks to hold for years. You'll almost certainly do better than letting someone else manage your money in active funds.