By Mickey Welcher
Mutual funds are the 800-pound gorilla in the financial industry. They are used by financial advisors, in most 401k plans, and by individual investors that go directly to the fund companies. You see these companies advertising in TV commercials and in magazines and newspapers. They all sound great, but there are the hidden truths they do not tell you.
Fees and Expenses
All funds have listed expense ratios that tell you what the cost is to the investor, but these ratios only tell a small part of the story. Let’s use the Fidelity Contrafund as an example. This is a very good 5-star fund with an expense ratio of .70 percent. On its face, that’s not too expensive for an actively managed fund. However, below the surface, the expenses add up.
First, when the fund buys or sells stocks, there are transaction costs or commissions. These costs are charged to fund holders. The Contrafund has a 35 percent turnover, which means there is a decent amount of buying and selling. What’s more, this and other funds tend to buy large amounts of stock at above market price and pass those additional charges to shareholders.
There are other fees that a fund charges, such as research or brokerage services (so-called soft dollars), fees paid to advisors and a few other items. While all these extra expenses are hard to find on the prospectus, they can double the stated costs of the fund. In the case of the Contrafund, that .70 percent could grow to 1.5 percent. All of that comes out of shareholder returns.
There have been many studies on how fund managers perform, and they always fare worse than indices like the S&P 500, Dow 30 and so forth. In fact, anywhere from 80 percent to 90 percent of actively-managed fund managers don’t beat their specific index. Even when they do, the fund fees erase any additional gains, and often cause them to underperform.
Most people don’t realize that mutual fund shares are affected by other investors in the fund. Let’s say you own shares of the Contrafund in a taxable account (non-IRA) and then a big shareholder of the fund decides to sell some or all of their shares. The Contrafund, like most funds, keeps a certain amount of cash, which is usually not enough to cover a large sale or many sellers. When this happens, the fund is forced to sell shares of stock they own in the fund, which then triggers capital gains or losses. Doing so may cause you to have a capital gain in your account, subjecting you to a tax liability you neither caused nor planned.
Mutual funds are bought and sold after the market closes and it can take up to three days for the transaction to close. If you need the money right away, you’re often stuck. Few fund companies allow “intraday trading,” and those that do often require you to pay for the convenience. This is even more challenging as technology has enabled markets to move fast. If you’re not careful, you could get stuck holding the proverbial bag.
As an investor, you need to understand what you buying and that’s most especially true with mutual funds. Consider index funds instead. They can give you the same or possibly better returns, but without the other issues described above.
>> Subscribe to Times of San Diego’s free daily email newsletter! Click hereFollow Us: