Understanding the Limits of Mutual Funds

Many people only see investing through the prism of their 401(k) and mutual funds. Corporate retirement plans, now built to make saving even easier, have shifted emphasis from investing to retirement. Thanks to the shift, more people are saving for retirement. While having mutual funds in your retirement plan is an important aspect, it is not enough to maximize your investments. Being singularly focused you might miss more beneficial opportunities.

How would you like to be someone’s 6,247th best idea? Mutual Fund managers are constrained by the rules outlined in the fund prospectus. When a mutual fund becomes too large, the fund’s ability to invest efficiently deteriorates. As a fund becomes well known sometimes more and more investors participate, creating more assets to invest than there are good ideas in that asset class. In this scenario, the fund may not be as flexible and nimble as it was when net-assets were much smaller. Therefore, investing in that fund may not be as desirable as it was when it was early on. The flip side of investing in an unknown mutual fund money manager is not knowing how well they can invest money.

Mutual Funds Can Lack Transparency

The holdings of mutual funds are not disclosed in real time, making it harder for investors to know whether to reallocate or divest their assets. One drawback of investing in mutual funds is that investors don’t own the underlying stocks in a fund because the mutual fund owns the stock. Many mutual funds are only required to report once a quarter what they own so it is hard to know what was in it and for how long it was in the fund. Another concern is that investors have no control over which stocks are purchased and owned or sold in the mutual fund.

Mutual Funds Can Be Expensive

All mutual funds, load or no load, charge expense ratios, which is the annual cost to run the fund. Some funds charge loads(fees) up front or when selling a fund. This reduces the amount of money that gets to work for an investor. Not all mutual funds are created equal, some charge more and some charge less. These charges can include commissions, management fees, advisory fees, legal fees, and 12b-1 fees (for marketing expenses). Depending on your relationship with your financial advisor and how you work together, these mutual fund fees can be on top of what your advisor charges. Institutional share classes, like the ones you should see in your 401(k) are typically the lowest cost share class a mutual fund provider will offer retail investors.

Mutual Funds Lack Tax Efficiency

While tax concerns may not arise in tax-deferred investment vehicles such as 401(k) plans and IRAs, you may also have taxable investments. This is where individual holdings can offer you monetary benefits. Individual stocks are more tax efficient than mutual funds and should be utilized in taxable portfolios when the investor has enough assets.

If you find yourself in a situation that requires tax efficiency, you may want to reduce your exposure to mutual funds. With a mutual fund, an investor pays taxes on any annual distributions by the funds and again when they sell the funds. A fund investor increases the possibility of paying higher taxes. In addition, when a fund loses money, an investor may also owe taxes.

Individual stock portfolios do not pick up embedded gains. You can tax loss harvest on an individual security basis. Mutual funds limit the ability of an investor to harvest losses for tax purposes. A mutual fund manager can harvest losses within a fund, but an investor may only harvest losses when the fund is down by selling the entire fund. In a rising market this benefit is quickly lost.

In addition, donations of highly appreciated individual stocks can help you avoid capital gains when given to a charity, donor advised funds or a charitable trust.

Mutual Fund Investing Can Be Like Running With the Herd

Mutual fund investors can be adversely affected by their fellow investors. In a volatile market, if other investors panic and sell their shares, a fund manager may liquidate stocks at a gain or loss. An investor who wants to simply sit out the volatility can’t do that without enduring the loss caused by other investors. Mutual fund money managers make the decision to buy or sell to invest or raise cash for liquidations, without being mindful of the impacts on an individual investor. With individual stock portfolios the decisions can be customized to the investor.

Mutual Funds Can Be Diluted

How much diversification is enough? Most funds have more securities (often many more) than is needed to diversify properly. This over-diversification ends up diluting future returns.

Portfolio strategy is important. Empirical evidence has shown that investors need to buy at least 15 different stocks in each asset class they choose to invest in to lower unsystematic risk to acceptable levels.

The reduction of unsystematic risk after owning 30 stocks is negligible and investors may not benefit from owning more than that amount in any asset class.

This is why a prudent investor will own between 15 and 30 stocks per asset class. Each of our equity asset classes observes this rule of thumb. Our more aggressive portfolio sleeves have more holdings than our more conservative ones.