Most investors are familiar with the term “mutual funds.” If you’ve invested for any length of time I’m sure you’ve owned some. Major broker dealers, and all my competitors in our area, use them almost exclusively. But the problem is the “mutual fund” is totally obsolete. Let me explain…
A Brief History of Mutual Funds
First some history. The mutual fund was invented in 1924 by Massachusetts Financial services (MFS). It’s still around today and is known as Massachusetts Investors Trust. The mutual fund allowed small investors to pool their money and invest in common stocks just like the big boys. It was revolutionary. In those days, an investor had to be wealthy to buy stocks. You had to buy stocks in round lots of 100 or more shares. The small guy simply couldn’t afford to buy one “round lot,” much less a whole portfolio of them.
The mutual fund changed all that. For nearly 60 years, there was a limited menu of funds and companies who sponsored funds. Maybe a dozen major investment firms had menus of funds. During the 1980s the mutual fund industry exploded. People now had 401(k)s, IRAs and retirement plans to fund. The best way to do that was through mutual funds. Fund companies sprouted out of nowhere with new offerings. Today there are around 85 separate mutual fund companies. And the bull market has allowed them to do quite well.
But I’m here to tell you that the mutual fund is obsolete and may eventually go away. As one investment writer Meb Faber pointed out on a recent podcast. “I don’t understand why anyone would start a mutual fund these days. It just makes no sense.”
So, why are mutual funds still sold? And what is so wrong about them?
Well, you must understand incentives. Broker-Dealers have what’s called “preferred funds.” These are funds your broker wants your advisor to sell to you, the consumer. Why? Because the parent company gets a kickback for every dollar you invest. For instance, one midwest broker-dealer, that I won’t mention here by name, has been fined millions of dollars for not disclosing these revenue sharing agreements. You can Google it, it’s no big secret. They’ve been fined multiple times.
Now, theoretically the broker could invest in other funds that are more attractive, on your behalf. But the reality is they wouldn’t have a job for too long if they did that. Brokers are employees, not business owners.
When you buy a “load” or commission based mutual fund there are wholesalers to pay, administrative and marketing costs (12b-1) fees, plus your broker has to make a living, so he gets a commission as well. As a result, funds have very high cost structures. And they add up to well over 1% annually.
Mutual funds also are structurally inefficient for tax purposes. If your mutual fund manager is doing his job he will be buying and selling periodically. If someone invests in his fund (like you) he/she has to go out and invest in stocks or bonds. When he sells, you get a tax bill, even though you’ve never done anything. If investors get scared and sell, he has to sell to the stocks in his funds to accommodate those investors. When he sells, you get a tax bill whether you did anything or not. As you can imagine, this doesn’t work in your favor.
Mutual funds have been made obsolete by the proliferation of Exchange Traded Funds (ETFs). ETFs were invented in the 1990s by Standard & Poor’s to track the S&P index. At first, large investors could get exposure to the broad market indexes without having to buy every stock in the index. (By the way, there are 500 in the S&P and this would be very unwieldy.)
An ETF has a totally different structure than a mutual fund. An ETF has a fixed amount of shares. What this means is it trades like an individual stock. An ETF can hold lots of different stocks and investments. It can also buy and sell, but you don’t get a tax bill until you decide to sell. The decision is yours, just like owning an individual stock.
A research paper by Ric Edelman of Edelman Financial Group found that mutual funds cost investors up to 70 basis points annually in extra taxes, or 7 tenths of 1%. This may not sound like a lot, but over time this adds up.
ETFs aren’t marketed like mutual funds, who have teams of wholesalers, administrators, and salesmen to pay. The cost structure is totally different and much more consumer friendly.
And that’s why mutual funds are falling by the way side.
Savvy investors simply don’t invest in mutual funds. They understand this. They own individual companies in the form of stocks and bonds. They create their own mutual fund. Without the added costs.
So remember:
- Mutual funds are “sold” to consumers.
- They are sold because brokers have an incentive to sell them.
- Mutual funds have high cost structures compared to ETFs and individual stocks.
- Savvy investors don’t buy mutual funds.
At CSH Investment Management we design our own mutual funds catered to our clients’ needs. They are low cost and tax efficient. And unlike mutual funds, there are no hidden fees or undisclosed arrangements. We serve you and nobody else. If you’d like to read more about how we work, check out this article.
As always, if you have any questions about this article or anything related to investing, wealth management, retirement planning, business succession planning, or estate planning, please give us a call at 217-824-4211. We are always happy to chat with you!