Why you should hate Mutual Funds?

Why you should hate Mutual Funds?

For decades, mutual funds were the favored investment vehicle for the majority of the investing public. The primary reasons for their attractiveness are the simplicity in executing the investment ("all I do is place one call to my broker and I own all these stocks") and the perceived diversity within a particular fund ("I can't take a bad `hit? because I own so many different stocks within my fund"). As a result of this overly simplified view, money has flowed into the mutual fund industry at an incredible rate. In return, investors are treated to increasing fees, underperformance and aftermarket manipulation. Wise investors should reevaluate their reasons for choosing mutual funds and gain back control lost to these fund managers.

According to fund tracker Morningstar, between 1994 and 2000 the assets of stock mutual funds soared by 408% while fund expenses actually climbed in excess of 438%. The expense ratio, which every fund must disclose to the public, covers fixed overhead such as salaries, rent and research. In a December 2001 Forbes article titled "The Penny-Pincher", Vanguard founder John Bogle stated that the average mutual fund expense ratio is 1.6%. Now, take that off your perceived profit. Global funds have even higher expense ratios. That is just the tip of the iceberg. Tim Middleton, who presently writes for MSN Money, points out that anyone who runs a lemonade stand knows fixed overhead should decrease in percentage terms as sales go up.

Here's a warning: the costs that increase as assets grow (such as trading expenses) are not even included in a fund's expense ratio. According to Bogle, trading fees, and or soft dollar fees, (trading expenses over and above competitive rates), average about .80% per fund. When you include amortizing front-end sales loads and other costs, the average fund has about 3% in total annual expenses. For variable annuities, this expense number can easily double.

Once one incorporates the information uncovered by New York Attorney General Eliot Spitzer in his indictment of multiple mutual fund families, additional costs are exposed. In a September 2003 Wall Street Journal article, professors Jason Green of Georgia State and Eric Zitzewitz of Stanford concluded that the illegal trading of mutual funds, either after hours or during the day by hedge funds, cost investors anywhere from 0.5%-2% a year. Added to this is what Max Rottersman of Fundexpenses.com found deep within mutual funds? prospectus: a "shareholder service and transfer agency fee." The industry average is .20%.

The result of the mutual fund scandal is an exponential increase in liability coverage, as well as legal and administrative costs for all mutual fund companies regardless of their guilt or innocence. According to Don Bailey of insurance broker Willis Group Holdings Ltd. rates per $1 million of coverage have jumped to as high as $80,000 from $20,000 in the summer of 2004. For a large mutual fund company buying $300 million in liability coverage, that could mean premiums leaping to $24 million from $6 million. Such premiums are paid directly out of fund assets, meaning out of the wallets of fund shareholders, and not borne by the fund management companies, whose actions may have led to the increase. This should more than offset any decrease in management fees that Mr. Spitzer is pushing for. Total all these costs, and it is clear that mutual funds may just be the great American rip-off. Middleton puts it more bluntly: "Get your money out now and invest where management isn't selling out its investors. The industry is awash in high fees and there is no excuse to entrust your money to crooks."

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Unfortunately, most investors focus solely on performance, an incomplete measure of success. This narrow-minded thinking results in underperformance. To invest in what is currently working as opposed to structuring a portfolio that is balanced and diversified, the investor misses opportunities for long-term gain. Performance alone is the mindset of Wall Street and the mutual fund companies. For example, advertising is centered on performance. Advisors or sales reps only talk about performance. If you presently have more than one broker, advisor or mutual fund company, think about this for a moment: do any of your advisors either know or care what your other firms are holding, buying or selling for you? Their concern is what they can sell you. As a result, investors are sold whatever is working. Each fund is attempting to outperform the others with little or no concern to the investor. According to Morningstar Inc. over a 10-year stretch, up to 90% of U.S. stock funds in any one category will typically fall behind their category's benchmark index. The odds are stacked against you.