Avoiding the Traps of Mutual Funds

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Understanding the Pros and Cons of Mutual Funds

Investors are often very polarized about mutual funds. Many believe they are a ripoff and others contend the exact opposite. As usual, the truth is somewhere in between. At Learning Markets we feel that funds (as a concept) are a great way to invest and that the debate about whether mutual funds on the whole are good or bad is misdirected and too general to be productive.

VIDEO: Hidden Costs and Risks of Mutual Funds

There are issues with some funds and fund management methodologies that investors should be aware of and avoid. There is also misleading marketing information being promoted by some of the largest fund companies that is causing serious confusion about these issues. This article will explain what these issues are and how to avoid them.

Active Management vs. Indexing

In general, mutual funds are either actively managed or indexed. A mutual fund that is actively managed is designed to outperform their benchmark indexes by “actively” buying and selling securities. On average however these funds have two drawbacks. First, they charge very high fees each year and second they don’t outperform the indexes on average. This is usually the answer to the question that investors ask; “why are my funds up less than the market this year?” The marketing used to sell these funds often suffers from survivorship bias. In the video we will discuss what this is and why it is misleading.

By contrast, indexed funds don’t try to outperform the indexes they try to replicate them. That is generally an achievable goal and because indexes are not changed frequently they do not not need to be actively managed. This keeps costs very low, which makes a significant difference in long term compounded gains. When evaluating a fund it is usually a good rule of thumb to try use low cost index funds. There is no way to tell that an actively managed fund will outperform the index in the future and the averages would tell us that it is a bad bet.

Barriers to Entry and Exit

Funds often come with handcuffs that can make leaving very expensive. It is quite common for a mutual fund to charge a redemption fee of 1-2% (these are limited to 2% by the SEC) if the fund has been held for less than a specific period. These are unnecessary (they limit your flexibility and control) and can add unanticipated costs to your investing.

Quite often mutual funds require a minimum investment amount to participate. Having to invest in such large increments can be prohibitive to many investors and may make you feel trapped within a suboptimal investing solution.

Alternatively, investing in Exchange Traded Funds (ETFs), which are a version of mutual funds listed on stock exchanges can offer solutions to the flexibility problems mentioned above. ETFs are usually indexed and are almost always lower cost than the average mutual fund. They can also be purchased like a stock from any brokerage account.

ETFs offer all of the advantages of mutual funds without most of the disadvantages. They trade like a stock and can be purchased in very small increments and traded at will. There are almost no restrictions on how many shares of an ETF you may hold, how long you have to stay invested or how many of them you can have within your portfolio. Many ETFs also have options available on them, which can provide another level of control over your investments.