Mutual funds are hazardous to your wealth.
Most investors sustained serious damage to their wealth last year -- damage that, in many cases, will be difficult to recover from. Certainly Wall Street titans, reckless lenders and irresponsible home buyers all deserve their share of the blame.
But one part of the financial world has not received much scrutiny for its role in the evaporation of investor wealth, and that is the mutual fund industry.
Mutual funds control the majority of Americans' retirement assets through 401(k)s, IRAs and annuities. Sadly, a gullible public has bought into the idea that steady investments in mutual funds, regardless of market conditions, is the way to make their financial dreams come true. This is one of the biggest fallacies of investing, and why mutual funds are hazardous to your wealth.
To give you a sense of just how flawed the buy-and-hold philosophy advocated by the mutual fund industry was in 2008, just look at the numbers. According to the mutual fund industry's own Investment Company Institute, investors lost almost $3.7 trillion in mutual funds in 2008. Yet how often do you read about mutual funds leading the public down a losing path? How often do you hear about a fund manager whose performance was drastically lower than the benchmark?
My problems with mutual funds don't stop merely at poor performance or inept fund managers. There are serious problems with mutual funds that have more to do with the design and structure of these investment vehicles. In fact, there are so many fundamental flaws inherent with mutual funds that they have become obstacles to successfully growing your investment portfolio -- chiefly:
1. The fund's interests are at odds with yours
Mutual fund companies have one primary objective: to make a profit. Unfortunately, this profit is not for you, but for them. While I will never disparage a company for having a self-interested goal of making a profit, when that profit comes at the expense of your best interest it deserves condemnation.
2. No transparency of holdings
A murky understanding of what securities you own at any given moment is another fundamental flaw of mutual funds. This lack of transparency essentially leaves you guessing about what you own and why. I can't think of a more unsettling feeling in a bear market than not knowing if you have exposure to toxic assets.
3. No transparency of fees
Here again we have a lack of clarity, but this time it's about what kind of fees you are paying. Sure, mutual funds are required to tell you they charge fees, but do you really know what you're paying for? In this bear market, the last thing you need is to be hit with some obscure cost you don't understand. But mutual funds are able to bury the specifics of their often very high management fees, which means you really have no idea what you are being charged.
4. All invested, all the time
The charter of most equity mutual funds compels the fund's manager to be allocated to stocks in virtual perpetuity. Most funds must maintain a significant allocation to the market no matter the conditions. It doesn't matter if stocks descend to near Depression-era values, according to their charter most fund managers must remain almost fully invested. To be sure, a small percentage of funds don't have that restriction, but most do.
5. Peddling bad advice
Perhaps the most onerous of these flaws is the bad advice that mutual funds dish out. Fund companies have incentive for you to be in the market all of the time because that's how they make money. It doesn't matter if the market undergoes a downward spiral the likes of what it did in 2008. The mutual fund folks want you to stay the course, and that's what they'll advise you to do.
Advocating buy-and-hold investing is the backbone thesis of most mutual funds. A fund company will never tell you to move to cash when things get tough because it's just not in their best interest. Because most mutual funds must stay fully invested all the time, their concern for managing risk is secondary to their concern for keeping you fully invested.
[by Doug Fabian, president of Fabian Wealth Strategies and editor of the Successful Investing and ETF Trader newsletters]