Nearly half of American households invest in mutual funds. However, popularity doesn’t equate to quality – investing in mutual funds can be a poor investment strategy. If you own mutual funds, you may be surprised to hear our reasons why mutual funds are not a good investment.
“Stock picking” rarely works
Mutual fund managers attempt to outperform the markets by using stock analysts to pick individual stocks to produce higher returns than the market as a whole. The theory behind the strategy of stock picking is that if you can buy only the best stocks in the market and avoid the worst, your mutual fund should easily outperform the market it seeks to beat. Unfortunately, the evidence shows that stock picking rarely works and the majority of mutual funds underperform simple market indices that invest in all or most of the stocks in any given market.
No investor can predict the markets. Your chances of picking a mutual fund that outperforms a specific stock market index looks more like Vegas odds than an investment strategy. In 2018, only 38% of the 4,600 active mutual funds beat their comparative market index during that year. If we extend that view over the last 10 years, it gets worse. Only 24% of active mutual funds beat their target market index. Prudent investors that invested in index funds instead of mutual funds over the last 10 years had a 76% greater likelihood of achieving better performance[1].
The longer you hold a mutual fund the lower your long-term returns are likely to be
Many professional investment advisors weigh past returns heavily when selecting mutual funds for their clients. Mutual funds with the best recent performance usually attract the most new investors. Research shows that picking mutual funds based on past performance is a poor choice because mutual funds that have performed well in the past, usually do not continue to outperform.
Of the top performing 25% of actively managed mutual funds at the end of 2016, only 7% of those funds remained in the top 25% after three consecutive years. Even worse, only 1.4% of the top performing mutual funds remained in the top 25% performance ranking after five consecutive years[2]. Mutual fund performance appears to be a function of luck instead of stock picking skill by the mutual fund manager. The bottom line is that you face uncomfortably high odds of accumulating less wealth by investing in mutual funds instead of index funds.
Mutual funds are structured with inherent disadvantages
In addition to the likelihood of lower long-term performance, mutual funds erode an investor’s potential returns through high fee structures and tax inefficiencies. The commissions for trading mutual funds can be very high as well, depending on the fund and broker used for trading. Furthermore, mutual funds can only be traded at the end of the day, unlike a stock or index fund that can be traded anytime throughout the day at the current market price.
Perhaps the biggest disadvantage of mutual funds is also the reason that mutual funds remain such a popular investment. Many mutual funds have built-in conflicts of interest because many non-fiduciary investment advisors receive minimally disclosed fees through fee-sharing agreements with the mutual fund manager. Investment advisors can receive a fee kickback when they invest their clients’ money in those mutual funds, regardless of the fund’s quality.
Take another look at your investment portfolio
If you own mutual funds, the new year is a good time to re-evaluate
your investment strategy and improve your chances of generating higher returns
and more wealth over your investing time horizon. If you would like
professional assistance in evaluating your investment strategy and portfolio
please call (571-565-2161) or email
us, we are always happy to help. Also consider learning more about this
topic and gaining unique investing insights by listening to our popular podcast
or viewing our investing video
series.
[1] Morningstar Active Passive Barometer 2018
[2] S&P Dow Jones SPIVA Research, September 2018
