Is Mutual Funds Investing for You?
Posted: November 17th, 2008 | Author: Mo2 | Filed under: Investing, Mutual Funds | Tags: Advantages and Disadvantages of Mutual Funds, balanced, Finance, indexes, Investing, Management Expense, MER, Mutual Funds, saving, stock market |My Vision
I must admit I have a pretty strong opinion on quite a few things in this world and mutual funds would be one of them. I’m not saying that you should follow my advice but I’m just giving my advice from my knowledge and experience here. If that didn’t scare you away, please read on. The topic of Mutual Funds is immense and I will therefore break this colossal topic down into a few parts. The first part is about what mutual funds and its costs.
What Mutual Funds Are
Mutual funds are probably one of the most well known investments. Essentially a mutual fund is a pool of investments that are held by either a corporation or trust that is then managed by a professional fund manager. With this pool of funds, the fund manager invests in all sorts of investments depending on their style of investing and the type of fund.
For example, if the mutual fund was an index-fund, the fund manager would strive to mimic the movements of the market, which basically is all an index fund does, try to get the same return as the index.
Mutual Fund Advantages
The greatest advantage of mutual funds is diversification. Because mutual funds are well capitalized in most cases, they can invest in any stock while keeping commission fees low compared to the regular investor.
Variety
Another advantage is the variety of mutual funds that exist. You can buy mutual funds that look for value stocks, growth stocks, REIT stocks, or wind power. It’s all there you just need to decide what you like and the fund manager will take care of the rest trying to produce the highest return possible.
There are other advantages that make mutual funds attractive however I feel that these two stand out the most.
Mutual Fund Disadvantages
Just as how great heroes have just as great villains, mutual funds have their disadvantages.
The first great disadvantage is the Management Expense Ratio (MER).
The calculation of the MER is as follows:
(All fees and expenses payable during the year divided by the average net asset value for the year) x 100
Some see that the professional management of funds is a great advantage to mutual funds. I agree to some extent because the fund managers have access to a wealth of information and their experience and education has achieved them the role of being a fund manager, which I might add is a formidable accomplishment in itself. However, the existence of the MER puts even the greatest of fund managers at a great disadvantage.
Here’s Why
“Hey Mo2 here’s $2 billion, invest it.”
Yes, I would love someone to say that to me. If you’re one of those beautiful people, you have my e-mail.
Guess what most mutual fund managers invest in with that amount of money and with all the restrictions that are placed on them (i.e. maximum short position on stocks)? If you own a Canadian Equity Mutual Fund, guess what? I’m going to have to invest in pretty much what every other fund manager invests in, the large capitalization stocks that are stable over the long term and pay out a decent dividend.
Most mutual fund managers will not deviate from that formula because their jobs on the line if they cannot produce a decent return for the mutual fund relative to the benchmark. Of course, they will try a variety of things such as invest heavier in certain stocks or diversify their risk by investing a small portion is relatively riskier stocks; however, this does very little offset the deadly blow of the MER.
Chipping Away at Your Return
Yes, that’s exactly what the MER does. If you didn’t have to deal with the MER and actually spent time on your own to do research and invest in individual stocks by yourself you would save plenty of money. For those of us that aren’t active traders but are normal investors (I’m kind of both so please don’t take offense traders) the usual commission per a 1,000-share equity (stock) order is around $25-29 per transaction. So double that when you consider selling it.
The commission fee for active traders by the way where they must have a certain number of transactions per quarter is around $9.99. That’s the commission fee you see on commercial and most likely doesn’t apply to the average investor.
The $3,000 Portfolio
Now, even if you’re beginning to start your portfolio and have as little as $3,000 that’s less than 1% to start your investment portfolio. If you think like Warren Buffet and decide that a person should invest in only 10 stocks in a lifetime, then you won’t have to worry about the other 1% for selling the stock.
Even if you do sell your stock for an investment portfolio of $3,000 that would only amount to being 2% of your investment over whatever period of time. And that could be 3-4 years too. Remember, the MER is an annual expense that is usually around 2.5-3% for a mutual fund depending on how active (and sometimes greedy) the management is.
Costs
More costs? That’s right, MER isn’t the only cost you have to deal with for mutual funds. Mutual funds usually have one of: front-end load, back-end load, or no-load fees.
Front-End Load Fees
This type of fee is deducted before you start investing in the mutual fund. Therefore if the front-end load fee is 4% then when you invest $3,000, $120 is deducted immediately leaving you with $2,880 invested. Just remember when you lose 4% that doesn’t mean you need 4% to regain the $120, you actually need more (around 4.17% to be exact).
Back-End Load Fees
Back-End load fees are charged when you exit the fund. Fund managers want to lock in your money and they don’t enjoy people moving in and out of their funds. Therefore, this type of fee gives you, the investor, an incentive to stay with the fund because the fee will decrease the longer you stay in the fund.
For example, if you exit a fund in the first year they could charge 5% and reduce that to 0% in the 6th year.
No-Load Funds
Mo2 you’re wrong! Not all mutual funds have a load fee. True, you may be right about that. But guess what, they make it back elsewhere. This is where we go back to the MER. Compare the MER of a no-load fund to a regular mutual fund that has a front-load or end-load and guess what? You’ll notice most of the time that no-load funds have a higher MER, hmm…I wonder why.
Mo2 Thinks
I guess you figured by now that I’m not exactly a huge fan of mutual funds. Although I do think mutual funds are a great way for smaller investors to start investing, even then I still think they should do their homework and look for individual stocks to invest in. I’ve never bought a mutual fund and most likely never will because I’m willing to take the extra step and be responsible and control my own investment portfolio.
Sure, I might not be able to own 25 stocks in my portfolio right off the bat. But over time you can build your own portfolio by keeping your costs at a minimum and yet possibly do better than fund managers. It can be done, and it all depends on how much time you’re willing to commit to understanding the construction of your investment portfolio.
I see mutual funds as a lazy way to get into investing. I often see mutual fund managers have similar picks and generally similar views of stocks, that’s because the larger funds are looking at the same things. Having said that, I do admire mutual fund managers that look at micro-cap or small cap stocks because that’s extremely challenging. The only time I would probably look at mutual funds is to learn from what they are doing. Again, I’m not taking anything away from mutual funds or the managers because I think the idea of mutual funds is brilliant the people that run them are exceptional. I really do mean this.
However, for the average investor there are ways to do well on your own. And my goal here is to have you try and figure this crazy puzzle of investing on your own. I’ll help in my own way but understand that it cannot be done overnight and could possible take a lifetime. I’m probably relatively risk tolerant to most people therefore this is my opinion, for those of you that just cannot bare to see your stock plunge 15-20% (and this does happen quite often) then you might want to stick with a mutual fund it is safer afterall.
But even for those that are willing to start their own fund (as in investment portfolio) and remember to diversify and never “put all your eggs in one basket.”
I know for a fact that there will be those that completely disagree with what I said. But just as how the discussion of the random walk theory is endless, this is too. I respect opposing views and would love to hear your opinion. However, I do not plan to write a 30-page paper on this. I vowed not to write any more illogically and needlessly lengthy papers after graduating university. So please don’t tempt me to write a book on my argument. Anyhow, happy investing!
Leave a Reply