Why Mutual Funds Are Lousy Long-Term Investments

[garylspolar]

Many of you on Yahoo may have seen this by now, but I'll post for those of you that haven't. I invest in individual stocks myself, with the help of a financial advisor, for several reasons. I avoid mutual funds for the reasons stated in this article, among others.

by Robert Kiyosaki

Why Mutual Funds Are Lousy Long-Term Investments
Tuesday, June 27, 2006

This past Christmas, I was at a party, and a man who's about 10 years older than I am asked me what mutual funds I invested in. My reply was "None. I rarely invest in mutual funds because of the lack of transparency. I don't know their fees. And I know there are hidden expenses they don't need to disclose to investors."

Hearing that, he nearly choked on his spiked eggnog. "What do you mean there's no transparency? My mutual-fund companies send me a report every year." Getting into an argument over mutual funds at a holiday party is not a way to enjoy the season. Rather than offer my information where it wasn't wanted, I thought it better to explain further to readers why I don't invest for the long term in mutual funds.

Fee Problem

A vast number of people think that investing for the long term in a diversified portfolio of mutual funds is the smart thing to do. In my opinion, this ranks among the worst possible investments.

The problem with funds is fees. The longer you invest in a mutual fund, the more you pay in fees. I've pointed out before that when I buy a piece of real estate or a stock, I pay the sales commission once, but when I purchase a mutual fund, I pay a sales commission for as long as I own the fund (see "So Long Pensions, Hello Fees" ).

That's why the return on investment is much lower on mutual funds -- and why gains get lower the longer you own them. The reason most financial planners recommend you invest for the long term is simply because the longer you hold on to the fund, the more money they make.

How Much Do Fund Companies Make?

Just how much does a fund company make from investors who hang in there for the long term? John Bogle, the founder of the very successful Vanguard Group, shed some light on that.

He was asked by an interviewer with the TV program "Frontline," "What percentage of my net growth is going to fees in a 401(k) plan?" Bogle replied, "Well it's awesome. Let me give you a little longer-term example. An individual who's 20-years old today [is] starting to accumulate for retirement.... That person has about 45 years to go before retirement -- 20 to 65 -- and then, if you believe the actuarial tables, another 20 years to go before death mercifully brings his or her life to a close. So that's 65 years of investing. If you invest $1,000 at the beginning of that time and earn 8 percent, that $1,000 will grow...to around $140,000."

He continued: "Now the financial system -- the mutual-fund system in this case -- will take about 2.5 percentage points out of that return, so you'll have a net return of 5.5 percent, and your $1,000 will grow to approximately $30,000 to you the investor."

"Think about that. That means the financial system put up zero percent of the capital and took zero percent of the risk and got almost 80 percent of the return. And you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only a little bit over 20 percent of the return. That's a financial system that's failing investors because of those costs of financial advice and brokerage, some hidden, some out in plain sight, that investors face today. So the system has to be fixed," said Bogle.

In other words, the longer you invest, the more the investment house makes. That's why the financial institutions recommend you invest for the long term.

Occasionally, I will buy a mutual fund. But I'll never hold it for a long period of time.

So What Should You Invest In?

The next time you hear a financial expert recommend that you "invest for the long term in mutual funds," take a moment to ask them to explain how their fees work over the long run. I suspect you'll hear some interesting answers -- if they can answer the question.

The reason they'll probably not be able to give you a definitive answer is because most financial experts don't know how much a mutual fund's fees and expenses are as most funds aren't required to disclose all such charges. In other words, there's no transparency.

If you're a passive investor, you may want to consider investing in index funds, which Mr. Bogle's fund company, Vanguard, specializes in (though not exclusively). Simply put, index funds have lower fees so the investor has a chance of making more money. After all, isn't that why we invest?

While index funds have the potential of generating greater returns via lower fees, I would still prefer to be an active investor. Most index funds think a 10 percent to 25 percent return is a good rate. Active investors can regularly beat those gains, especially if they stay away from traditional investments such as savings, stocks, bonds, and index and mutual funds (for more on being an active investor and not a passive one, see "To Diversify or Not to Diversify" ).

Summarizing what Bogle is saying, if you invest in mutual funds for a long period of time, this is a simplified picture of how the return is split over the long term -- and who takes the risk.

Mutual-Fund Company Investor
80 percent of the return 20 percent of the return
0 percent of the capital 100 percent of the capital
0 percent of the risk 100 percent of the risk
If you don't like the above distribution of returns, I suggest you contact John Bogle or try index funds.

[beemerphile]

I agree that domestic mutual funds have huge drawbacks and I no longer own any, but they were useful to me before my portfolio was large enough to establish adequate diversification with individual stocks. I still use them for international investments because I don't have the time or knowledge to research the overseas companies directly. I made a lot of money on Matthews funds for India and several of the Far East countries over the last couple of years, but I sold all of them too in about May as they had gotten ahead of themselves with a rush of late investors. The old saying "Sell in May and walk away" held pretty true this year worldwide. If Matthew made a ton of money on me, that is fine, because I made a ton too and I couldn't have done it by myself in those markets. Between May and October I'll just roll it from currency to currency and then load the boat for another round.

...unless gold and silver sink really low, then...

Bogle is a smart and good man and he genuinely loves index funds, however, the pitch for index funds as a replacement for domestic mutual funds is only great advice in a secular bull market. There have been 15 year periods where it would have been dead money. I think such a period is coming. I'd either sell naked calls on QQQ or lacking the brass cajones to do that buy a few companies in the business of fresh water properties or infrastructure and take a 10 year nap.

Lee

[wncbmw]

It might be better advice to use Mutual Funds with a history of low fees. Buying individual stocks requires some research and expertise I don't begin to have and sounds like the prelude to losing everthing! If you rely on a financial adviser, do you pay him? Isn't that a fee?

Of course, with my 401(k), I don't have the choice of individual funds, so I just spread it around, including foreign funds.

I don't have the option of buying gold with the 401(k) funds, Lee!

[rdsmith3]

Your best bet is no-load index mutual funds. You will pay something like 20 basis points for management fees, and no other fees. You wil beat the performance of most active managers, including yourself.

Support for this is found in many places, including this from the 6/27 Wall St. Journal.

COMMENTARY

Turn on a Paradigm?

By JOHN C. BOGLE and BURTON G. MALKIEL
June 27, 2006; Page A14

As index funds gain an increasing share of the portfolios of mutual funds, institutional equity and bond funds, academics and practitioners are hotly debating how these portfolios should be composed. Capitalization-weighted indexing, until now the dominant approach, has come under fire for overweighting portfolios with (temporarily) overvalued stocks and underweighting them with undervalued ones.


Eugene Fama and Kenneth French have suggested that higher returns can be generated by indexed portfolios of stocks with small capitalizations and low price-to-book-value ratios. Robert Arnott has argued that a better method for indexing is to weight the stocks in the index not by their total capitalization, but rather by certain "fundamental" factors such as sales, earnings or book values. Jeremy Siegel has proposed that the "fundamental factor" should be the dividends that companies pay. These analysts have all argued that fundamentally weighted indexes represent the "new paradigm" for index-fund investing.

Are they correct? We think not. There is no doubt that fundamentally weighted indexes have outperformed capitalization-weighted indexes during the past six years, which witnessed the collapse of the "new economy" bubble and partial recovery. But we need to be cautious before accepting any "new paradigm" that implicitly suggests that the "old paradigm" -- reflected in more than $3 trillion of capitalization-weighted index investment funds -- is in error. During the three-plus decades that such passively managed funds have been available, they have provided for their investors returns substantially superior to the returns achieved by actively managed equity funds. We need to understand why capitalization-weighted indexes make sense -- even if market prices are "noisy" and can fluctuate above or below the values they would have in a perfectly efficient market.

* * *
First let us put to rest the canard that the remarkable success of traditional market-weighted indexing rests on the notion that markets must be efficient. Even if our stock markets were inefficient, capitalization-weighted indexing would still be -- must be -- an optimal investment strategy. All the stocks in the market must be held by someone. Thus, investors as a whole must earn the market return when that return is measured by a capitalization-weighted total stock market index. We can not live in Garrison Keillor's Lake Wobegon, where all the children are above average. For every investor who outperforms the market, there must be another investor who underperforms. Beating the market, in principle, must be a zero-sum game.

But only before the deduction of investment management costs. In practice, investors as a group will fail to earn the market return after these costs, and as a group, they will fall far short of the low-expense index funds. For the typical actively managed equity mutual fund, annual operating expense ratios are well over 100 basis points (one percentage point). Add in the hidden costs of portfolio turnover and sales loads, where applicable, and effective annual costs are undoubtedly considerably higher, perhaps as much as 200 to 250 basis points. In total, simply because the average actively managed fund must underperform the capitalization-weighted market as a whole by the amount of financial intermediation costs that are deducted from the gross return achieved, active investing must be, and is, a loser's game.

Purveyors of fundamentally weighted indexes also tend to charge management fees well above the typical index fund. While index funds also incur expenses, they are available at costs below 10 basis points. The expense ratios of publicly available fundamental index funds range from an average of 0.49% (plus brokerage commissions) to 1.14% (plus a 3.75% sales load), plus an undisclosed amount of portfolio turnover costs.

The portfolios of market-weighted index funds are automatically adjusted for changes in the market caps of their portfolio holdings, and they require no turnover. But fundamentally weighted indexes gain no such advantage. Suppose, for example, we use a fundamental index based on dividends. If one company doubles its dividend, the portfolio manager then needs to buy enough of the stock (and sell enough of the other stocks) to double the weight of the stock in his fundamentally weighted portfolios. All fundamentally weighted indexes must incur turnover costs to align the weights of the portfolio with changing fundamental factors and changes in the market price of different securities.

Fundamental weighting also fails to provide the tax efficiency of market weighting. If a stock doubles in price and its fundamental weighting factor (be it dividends, book value or anything else) remains unchanged, the portfolio manager must sell enough of the stock to bring its weight back into balance. Thus, a fundamental index fund will tend to realize capital gains (and highly taxed short-term gains if adjustments are made frequently). Taxes are a crucially important financial consideration because the premature realization of capital gains will substantially reduce net returns.

One important characteristic of fundamental indexing needs to be emphasized, for it explains why such indexing can often appear to produce outperformance. Every method of fundamental indexing tends to overweight smaller capitalization stocks and so-called value stocks. Consider the rationale for fundamental indexing. If, during some speculative bubble, money pours into high-tech stocks, their weight in a cap-weighted index increases. Since their price rise generally exceeds any fundamental measures of value, such as dividends or book value, such stocks will tend to have increased cap weights versus fundamental weights.

Consequently, fundamental weighting will tend to produce portfolios that give more weight to companies that are smaller in size (capitalization) and that have "value" characteristics such as low prices relative to earnings, dividends, sales and book values. Fundamental indexing will tend to do well in periods when small-cap stocks and "value" stocks tend to outperform. Thus it is not surprising that most of the long-term excess return attributed to fundamentally weighted portfolios was achieved between 2000 and 2005 alone, one of the best periods in history for the relative returns of dividend-paying stocks, "value" stocks and small-cap stocks.

We concede that there is some evidence, based on numbers compiled by Ibbotson Associates, that long-run excess returns have been earned from dividend-paying, "value" and small-cap stocks -- albeit returns that are overstated by not taking into account management fees, operating expenses, turnover costs and taxes. But to the extent that investors are persuaded by these data, the premiums offered by such stocks may well now have been "arbitraged away" in the stock market, as price-earnings multiples have become extremely compressed.

We are impressed by the inexorable tendency for reversion to the mean in security returns. Consider the chart showing the difference between mutual funds with a "value" mandate and those with a "growth" mandate. Since the late 1960s, "value" funds have generally outperformed growth funds. But since 1977 -- indeed since 1937 -- there is little to choose between the two. Indeed, for the first 30 years, growth funds rather consistently trumped value funds. Never think you know more than the markets. Nobody does.

We never know when reversion to the mean will come to the various sectors of the stock market, but we do know that such changes in style invariably occur. Before we too easily accept that fundamental indexing -- relying on style tilts toward dividends, "value" and smallness -- is the "new paradigm," we need a longer sense of history, as well as an appreciation that capitalization-weighted indexing does not depend on efficient markets for its usefulness.

While we have witnessed many "new paradigms" over the years, none have persisted. The "concept" stocks of the Go-Go years in the 1960s came, and went. So did the "Nifty Fifty" era that soon followed. The "January Effect" of small-cap superiority came, and went. Option-income funds and "Government Plus" funds came, and went. High-tech stocks and "new economy" funds came as well, and the survivors remain far below their peaks. Intelligent investors should approach with extreme caution any claim that a "new paradigm" is here to stay. That's not the way financial markets work.

Mr. Bogle is the founder of the Vanguard Group. Mr. Malkiel is the author of "A Random Walk Down Wall Street" (Norton, 2004).

[beemerphile]

It might be better advice to use Mutual Funds with a history of low fees.

It was John Bogle who more-or-less invented the Index Fund with his Vanguard 500 that tracks the S&P500. He carried the low fee structure into the other Vanguard funds making them lower cost than his competitors' managed offerings. I still have a Vanguard account because of the company's history of integrity towards its customers. I use it as a brokerage account and buy a ETF's (GLD and SLV) and international funds through their FundAccess.

I don't have the option of buying gold with the 401(k) funds, Lee!

That is unfortunate. The couple of times that I changed employers I rolled the 401K's into my Vanguard Rollover IRA so that I could do just that. Do you have a prior employer's 401K? Now that I am one of the company owners where I work, I wanted to give our folks the best variety in a 401K but it just isn't easy to offer. Management fees will cut you hard in 401K plans too and we had to look for the best low-fee options, which limited what we could offer. - Lee

[scottybooj]

From what I've been hearing from some very 'well heeled' investors is that there are many good Mutual Funds (no-load) that are off-shore and have proven to be quite safe and very liquid.

I will be learning about these soon from them. We'll see what they are.