Why Mutual Funds May Not Be Your Best Option

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Newly minted investors often turn to mutual funds to meet their financial goals and expectations instead of trading stocks on their own. The idea of taking the fate of your portfolio into your own hands can be intimidating and the availability of investment vehicles that offer diversification and automatic management all-in-one almost makes the decision seem like a no-brainer.

But, despite the proliferation of mutual funds in the investment industry, they might not be the bargains they appear to be. There’s been a lot pf discussion lately about the importance of mutual funds in a portfolio and whether or not they actually add more value than ETF’s, stocks, or index funds. There’s also evidence that most mutual funds consistently under-perform benchmark indexes, such as the S&P 500, indicating that the age of the mutual fund as an investment portfolio pillar may soon be coming to an end.

The Hidden Disadvantages of Mutual Funds

Most mutual funds appear to be complete investment vehicles with built-in diversification and professional management. But when we compare them to other investment vehicles and strategies, mutual funds tend to lose their luster.

While mutual funds have built-in management, either by an individual or a team, management is limited in what they are allowed to do. Manager’s aren’t free to invest as they please – they are required to invest within certain guidelines and maintain certain percentages of their holdings in line with what the fund is designed to do. This can hurt overall performance by preventing managers from making changes as the economy ebbs and wanes along the natural business cycle.

Mutual fund returns need to be taken with a grain of salt, as well, considering they come with an expense ratio. This ratio basically covers the fees for management and marketing of the fund, but work against the total return of the fund. In other words, even if a mutual fund manages to keep pace with the broader indexes, it will still provide a lower return for investors.

In order to determine which funds are doing well and which aren’t, we can look at a fund’s alpha ratio. This tells us how the fund is doing relative to its benchmark index. A high alpha indicates the fund is beating the index, while a low one lets investors know it’s lagging. This ratio can be misleading as it doesn’t follow management – it follows the fund. So a fund that has a new manager, but shows a high alpha isn’t necessarily reflecting the fund’s true potential.

Because mutual funds have been lagging the markets for the past several years, investors have begun transitioning to other options, like ETF’s. Money outflows from mutual funds have plagued the industry, while ETF’s have seen steady inflows. This suggests that investors are moving their money away from under-performing mutual funds with high fees and expenses to ETF’s, which offer more competitive gains for less.

An exception to this trend could be the index fund – a mutual fund that doesn’t have active asset management, but is designed to simply track a benchmark index. While investors might not get the downside protection a traditional mutual fund offers, index funds could replace mutual funds for long term investors looking to maximize their gains.