8 Dangers of Mutual Funds

With investing strategies, as in life, nothing's perfect. Professionally managed mutual funds often seem like the safe, no-brainer investment, and may be the only options in some accounts. But here are some things to be careful of.

1. You'll Often Have Performance Shortfalls Compared With the S&P 500 and Other Benchmark Indexes

Ever notice how many index mutual funds, which track specific indexes such as the S&P 500, lag their benchmark index? Even passively managed funds have costs, even though their expense ratios are often only around 0.2%. The fees are taken out of your return before it’s ever paid to you, so the lower the management fee, the closer your return should be to the index. 

For funds that are actively managed, performance is entirely unpredictable, so yesterday’s great idea may not pan out for tomorrow.

2. You'll Have Difficulty in Assessing Performance of Fund Investments

In the very short term, you don't know how well you're fund is performing. You won’t know the fund's net asset value until the market closes and the underlying assets are valued. In contrast, exchange-traded funds, which are baskets of holdings, trade throughout the day at a specific price, but these prices can vary from moment to moment just like stock depending on market sentiment. As with all investments, you can see past performance with a variety of measurements (annualized, specific periods, and rolling returns) and estimate risk based on available volatility measures. But past performance is not a reliable indicator of future performance: managers and markets change, and there is always the possibility of a “black swan” or capricious political actions that roil the market.

3. You'll Have Trouble Determining a Professionally Managed Fund's Current Holdings and Activities

You don’t really know what you’re investing in! Mutual funds are only required to disclose their holdings within 60 days of their quarterly report deadlines, and a whole lot of trading can go on during that time. This is less of a concern with index funds such as an S&P 500 fund, which should hew to the index, but with actively managed funds, you won’t know what moves are being made.

Active managers don’t necessarily want to disclose their strategies and move the market in unexpected ways. Check out the turnover rate of the fund. With low turnover, the top holdings will likely stay put, but with a fund that turns over 50% or 100% you’d better have faith in the manager. If a fund has an ETF equivalent, you might be able to monitor the portfolio more closely, as ETFs are required to disclose holdings every day.

4. You'll Be Surprised by the Effects of Tax Laws

You can end up paying taxes on mutual funds in several ways. If you sell a fund, you’ll have a capital gain (or loss). Fund companies are required to provide you with cost basis information, but this can be problematic if you bought the fund at a different investment house, then transferred your account. Your current investment home may not be able to retrieve the information.

You’ll probably receive some dividends, depending on the type of fund. REIT funds, value-oriented funds, small caps and emerging markets, and bond funds usually pay out more dividends than an S&P 500 fund. Some funds are “tax-managed”. They control types of investments to reduce dividend payouts.

The most unwelcome tax surprise, however, may come at the end of the year. Mutual funds (but not ETFs) may have had to make sales to pay off investors or simply to realign the portfolio, and the capital gains are passed along to investors, even if you haven’t sold any of your shares. Some companies issue early warnings on potential capital gains, but there’s not much you can do about a manager’s activities.

5. You'll Pay Ongoing Expense Ratio Fees and Other Costs

Be aware of several types of fees: the ones you pay directly and the ones you never see. Load funds (usually designated A, B, or C shares) charge you a commission as a percent of your investment. This is usually deducted directly from the money you’ve invested, and while your balance has gone down (often substantially), you haven’t had to write a check.

Next are asset management fees, which an investment adviser charges for advice. You should make sure your advisor is a fiduciary (not just a salesperson), so that the advice is in your best interests, not their commissions. If your portfolio is simple, you may not need this, but for complex planning issues it can help to have someone to turn to for personal advice and ongoing portfolio monitoring. Understand whether you’re being charged a flat fee, a retainer, hourly, or as a percentage of assets they manage (AUM).

Many fund companies have added “planning” or low-cost investment management. What are you you paying for: will the advisor only recommend funds from that company? Is the recommended portfolio any different from a target date or balanced fund? Are taxes considered when sales are recommended? Are the rest of your planning needs considered? (e.g., insurance, long term care, estate planning, college financing).

Finally, there are the internal management fees on nearly every fund. You’ll never see these because they’re taken out of your returns, but every fund needs money to operate, and some funds (actively managed, international, strategic) cost more to operate than others. In general, lower management fees for a specific type of fund mean more money in your pocket.

These costs are a drag on your overall mutual fund performance, which we discuss in Measuring Mutual Fund Performance.

6. You'll Believe Your Portfolio Is More Diversified Than it Is by Investing in Mutual Funds

You don’t have much diversity if you have several large-cap funds, or balanced funds, or funds with different target dates. Funds of a similar type (even from different companies) are going to have very similar portfolios. Choose the mix you want in one target date fund or balanced fund, and scrutinize fund portfolios for asset classes and investment focus, or you’ll own Apple in every fund in your portfolio.

Even if you're an individual investor who isn't yet comfortable owning individual stocks, you can learn to handle your own portfolio of individual stocks with plenty of diversification. You can start by sampling BetterInvesting's free resources.

7. You'll Have Challenges When Buying and Selling Fund Investments

You won’t know exactly what you’re paying for: Mutual fund prices are determined at the end of the day. You can either put in an order for a dollar amount, in which case you won’t know exactly how many shares you’ll get, or you can buy a set number of shares, in which case you won’t know exactly what they cost until the order is filled. I usually recommend the dollar amount order because I don’t like to be surprised by market gyrations.

8. You Might Think a Fund Is Too Good to Be True

And you'll often be right. Don’t be swayed by promises of a special deal only for you, guaranteed performance, or getting on the bandwagon before it’s “too late”. They’re all sure ways to lose money, in any investment.

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