Mutual funds can be wonderful vehicles to build wealth over the long term, as they can provide a cheap means to owning a diversified portfolio of common stocks (or other assets). However, as is common in finance, there are a number of myths associated with mutual funds that may be harmful to your financial wellbeing -- some of which are actively promoted by the industry itself. We asked our analysts to identify mutual fund myths -- here are three:
Alex Dumortier: There is a myth that it is possible for individual investors to identify market-beating mutual fund managers. This idea is one that the industry has a vested interest in supporting, as so-called "actively managed" funds charge higher fees than passively managed ones (i.e., index funds).
Do I think it is possible for some investors to identify superior fund managers? Yes, but pursuing that goal requires enough knowledge, experience, and effort that it is outside the reach of nearly all investors. As such, most investors are better off treating this idea as just plain wrong.
In his 2013 Annual Shareholder Letter, Warren Buffett said he had recommended to the trustee who will oversee the bequest for his wife to put 90% of the cash into "a very low-cost S&P 500 index fund" (Buffett suggested Vanguard's). Coming from someone who is living proof that it is possible to beat the market, that advice ought to resonate loud and clear.
Dan Caplinger: There's a common sense that a mutual fund's expense ratio includes all of the costs a fund bears. In reality, though, there are several costs that don't get included in the expense ratio, and some of them can substantially add to the drag on returns in a way that can be hard to figure out from the numbers the fund is required to report.
The SEC defines expense ratio to include all annual fund operating expenses. These include the management fees that go to the fund's managers, as well as any 12b-1 distribution fees that go toward compensating brokers or other salespeople and the costs of advertising and other marketing efforts. It also includes a broad catch-all "other expense" category that covers things like custody fees, legal and accounting expenses, and other administrative expenses.
However, two big items aren't covered under the expense ratio. One is any sales load, either up-front or deferred, that investors have to pay when they buy or sell fund shares. The other is the outside cost of investing in the securities the fund holds, including purchase and sale commissions to the brokers who handle the fund's trading accounts. For funds that trade frequently, commission costs can add up to a sizable percentage of net assets, making what might have seemed like a reasonable level of costs based on the expense ratio look a lot less attractive.
Jordan Wathen: Look closely at your retirement plan, and you'll probably see a long list of funds with years in the name. Typically, they span every five years (2020, 2025, 2030...). These are target date funds. Target date funds are designed to automatically rebalance and pick new investments based on your expected retirement date. As time goes on, it's assumed that a 2050 retirement fund would become more conservative. But expectations don't always match reality.
In an effort to put up the best returns relative to their competitors, many simply take on too much risk. According to research from Boston College, target date funds for 2005 and 2010 retirees lost an average of 24% of their value during the 2008 financial crisis, despite the fact that these funds should have been very conservatively invested as their owners were retired, or planned to soon be retired.
More importantly, target date funds are designed for the average person. They can't take into account personal variables, like assets you own outside of the stock market, or your post-retirement income needs. Assuming a product designed for the average person will be invested in a way to match your risk tolerance and your retirement needs can be a very costly mistake.