How do I love mutual funds? Let me count the ways. Uh ... well, actually, there are a lot of reasons to not love mutual funds. Here are a few biggies:
Fees. One of the most important things for a mutual fund shopper to examine is a fund's fee structure. The expense ratio will show you how much is deducted in fees from your fund each year, in order to run it and keep the fund company afloat (and buy its managers big houses). Fees vary widely. Check out what the Securities and Exchange Commission (SEC) has to say about their impact:
"Even small differences in fees can translate into large differences in returns over time. For example, if 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 -- an 18% difference."
The average stock fund's expense ratio today is around 1%. As you might expect, though, the range is wide. The Vanguard 500 Index (FUND:VFINX) fund sports an expense ratio of just 0.18% and the Fidelity Spartan 500 Index (FUND:FSMKX) fund, along with a few other Fidelity funds, is cutting its fee to 0.10%. Vanguard's exchange-traded funds, such as its Vanguard Total Stock Market VIPERs (AMEX:VTI), has an expense ratio below 0.15%.
Loads. A fund's load is essentially a sales charge, usually levied when you buy into the fund or sell your shares. (The former is a "front-end" load, the latter a "back-end" load.) It can be as high as 8.5%, though I haven't seen many above 5.75%. Still, that's a heck of a load. Imagine that you plunk $10,000 into a fund. If you're socked with a 5.75% load, you lose $575 from the outset. If the fund earns 10% in its first year, instead of ending up with somewhere around $11,000, you'll have a total around $10,370.
Fortunately, you don't have to invest in funds with loads. You can easily avoid them, since many terrific funds are "no-load." (Beware, though -- some no-load funds charge such things as "purchase fees" or "redemption fees," which can also make a big difference.) In addition, some terrific funds do have modest or even sizable loads, and if they're terrific enough, it can still be worth paying the load.
Size. Size can be a big problem for funds. It may seem great to have billions and billions to invest, but it's actually hard to deploy those dollars as effectively as you could deploy $300 million. Plus, funds generally have overriding restrictions, imposed from within and without. They can't park more than certain percentages of their value into a single investment, no matter how compelling. They also can't buy more than certain percentages of a company. So if you, as a smart manager, rank your top 50 stocks, you can't just focus the money entrusted to you on your top 10 ideas. It's not practical, not mathematically possible, or simply not allowed. So the money gets spread out into less-promising investments.
Overdiversification . Then there's this one. Overdiversification happens when a fund has a lot of money, and/or its managers are trying to hedge their bets by investing broadly. (After all, if you're afraid you might not beat the S&P 500, why not essentially replicate it in your fund, with some tweaking to try to juice its performance a little, if possible?) We've often recommended that investors aim to hold between eight and 15 stocks -- enough to spread the risk around a bit, but not so many that you can't keep up with them all. Well, many mutual funds hold more than 100 stocks, and many hold more than 200 or considerably more than that. When this is the case, it's very hard to turn in a really strong performance. If a few of your holdings triple in value, they're still a drop in the bucket.
Check out Fidelity Magellan (FUND:FMAGX), for example. As of June 2005, it held stock in 215 companies. Its top holding was General Electric (NYSE:GE), with 4.13% of the fund's assets. That means that if you held $3,000 in Magellan, you owned a whopping $124 worth of GE stock, about three shares' worth. That might not sound like much because it isn't. But it's the top holding. Want to own Tyco or Wells Fargo? Owning Magellan will give them to you, but only about $50 worth of each. The 25th top holding was Genentech, making up 1.13% of the fund. Your $3,000 would give you $34 of the company, roughly a third of one share. I hope that by now you can just imagine how much of the 215th holding you'd own and what kind of difference it would make in your life.
The black box. What black box? Well, you generally can't tell at any given time exactly what you own when you own shares of a mutual fund. The fund's contents are typically disclosed just quarterly, and by the time you see that report, the fund may have closed out or be closing out a position, or it may have been buying boatloads of something new. It's also hard to tell exactly when a fund bought its shares of this or that, so for all you know, its shares of a wonderful, promising company may have been bought when the firm was trading at a way-too-high price.
Management. A fund's management is critical to its success. There are many brilliant folks brimming with integrity out there who are running funds successfully. And then there are . other kinds of people. Bill Mann wrote about a teenager accused of all kinds of poor behavior who was enlisted at some point to help run the Frontier Equity (FUND:FEFPX) fund. If you were a Frontier shareholder, you probably had little idea that this happened and what it meant.
Performance. Finally, there's performance. As we've trumpeted in Fooldom since our early days, the vast majority of managed stock funds underperform the market. In most years, more than 75% of those funds don't do as well as a simple S&P 500 or broad market index fund. You can invest in these indexes very inexpensively, and you should consider doing so. Even Warren Buffett has recommended them.
But wait!
Despite all my criticism above, some funds don't stink. Some are outstanding, in fact; they have performed well for many years and can be expected to continue doing so. If you seek above-average performance from your portfolio, you just have to find these funds. You can do so on your own, or if you'd like, we'd love to help you.
Take advantage of a free trial of our Motley Fool Champion Funds newsletter and see which funds our analyst Shannon Zimmerman is recommending. (Our newsletters have been pretty impressive -- see for yourself.) Together, his picks have roughly doubled the market's return (as of the last time I checked), with a bunch racking up double-digit gains in the past year. In fact, out of about 30 picks, none are underwater. Learn much more in these Zimmerman articles:
- The Case for Mutual Funds
- Slam-Dunk Mutual Funds
- You're Paying How Much?
- Champion Funds Still Beating the Market
- 3 Reasons to Sell
Longtime Fool contributor Selena Maranjian 's favorite discussion boards include Book Club , Eclectic Library, and Card & Board Games. She owns shares of Fidelity Magellan. For more about Selena, viewher bio and her profile. You might also be interested in these books she has written or co-written:The Motley Fool Money GuideandThe Motley Fool Investment Guide for Teens. The Motley Fool is Fools writing for Fools.
