Mutual funds are all the rage. Any financial institution will rush to offer you a mutual fund. They are billed as the safest investments as they offer superior asset allocation and diversification. It extends even to the government where IRS regulations mandate that 401(k)s must be mutual funds. I’m not convinced that mutual funds are all that great. I will explain below why I avoid them and when I believe is the proper time to use them.
First of all, let me dive into the biggest sell of mutual funds: diversification. That for a minimum investment (usually $1,000) you will get broad exposure and a professionally managed fund.
My issue with this logic is that mutual fund managers rarely, if ever, beat index based mutual funds. In fact, it’s so rare, I wonder why they even have jobs. The reason why they continue to have jobs is marketing. Managed mutual funds make substantial sums of money. The typical expense ratio of a managed fund is around 2%. Think about it; you give a money manager $1,000 and, in exchange, they get $2 whether they beat their benchmark or not. Many have caught on to this scheme and have shifted to index funds instead.
Index funds are mutual funds that are not actively managed by a money manager. If you were to invest in SPY you would be investing in assets that mirror the S&P 500.
The S&P 500 is an index managed by Standard and Poor’s that is comprised of 500 different companies. Various companies receive a distributed weighting based on various factors such as market capitalization, revenues, and share price. The actual metric of the index is far more complicated than this discussion, but I needed to make some mention of it.
So an index fund would mirror the weighting of the S&P Index and would auto adjust as new influxes of cash come into the fund and as S&P alters various weightings. Therefore, an active manager is not necessary since it will be managed by a system. In this scenario, the expense of ratio of the fund is much lower. These types of funds generally have an expense ratio around 0.30%. Sounds much better than an actively managed fund that’s between 1 and 2% right?
Well, here is my issue with index funds: it’s still charging you 0.30%. Why would I pay 0.30% if I do not have to? Even at $10,000 investment the $30 fee will start to eat away at returns. This is especially true when the market has a down year as the mutual fund fee is charged whether it is making money for the investor or not.
A typical stock price is normally between $50 and $100. This is for well known companies that would comprise the S&P 500 Index. At those price levels and with many mutual funds requiring a $1,000 minimum investment; you can buy 10 to 20 different single shares of excellent companies without having to pay the index fund fee on a recurring basis. You can essentially make your own mutual fund. Why pay a fee if you don’t have to; even if it is small?
Where I do like mutual funds are for the purposes of bonds. Many bond issues require minimum investment of $5,000 and many treasury issues have $10,000 minimums. 5,000 to 10,000 is a lot of money to have wrapped up in a single company. This is where having an index fund would make sense since you can tap into hundreds of companies for the $1,000 investment in the fund.
I hope you find the sense in this. Do you have any thoughts on mutual funds? If you have a 401(k); you have a mutual fund so what do you think of them?