Making The Case Against Mutual Funds – And Breaking It

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After writing all week about how great mutual funds are, it’s important to note that they’re not the be-all end-all of investments. Here are four good arguments for why you should not invest your money in mutual funds.

You can’t get exceptional growth from a mutual fund because the skyrocketing investments are held back by ones that aren’t skyrocketing. This is the big argument against mutual funds from the perspective of the individual stock investor, and it’s true: a single well-picked growth stock can utterly annihilate the gains from any fund.

They take a percentage of your money every year just for the “benefit” of holding it. Every year, a mutual fund takes a piece of your investment for their own – the expense ratio, to be exact. Other investments hold their original value without being slowly leeched.

The “success” of mutual funds is skewed by survivorship bias. In essence, survivorship bias means that the returns, on average, of an investment group’s mutual funds are higher than reality because investment houses kill poor funds quickly. They kill off all the bad ones and then average the ones that remain. Of course you can beat the market if you “cheat” like that.

Funds are marketed like anything else – and you pay for that marketing. You know the ads you see in magazines touting how great a fund is? You directly pay for them through special fees called 12b-1 fees. Not only that, the ads are designed to make the fund appear better than it actually is.

So why should you invest in mutual funds at all? They take your cash, stunt your returns, and lie to you about how great they are… why even invest in them? Well, each of these arguments has either a fatal flaw or a strong counterargument. Let’s walk through these one by one.

First, you can’t get exceptional growth from a mutual fund because the skyrocketing investments are held back by ones that aren’t skyrocketing. This is true, but you also can’t get exceptional loss from a mutual fund, either. Owning Enron individually would have bankrupted you, but owning a fund with Enron in it would have just been a little bump in the road.

Second, they take a percentage of your money every year just for the “benefit” of holding it. Obviously, someone has to put in the time to actually manage the fund and actively managed ones can be expensive, but you can really reduce this expense ratio by focusing on index funds. Many of them have expense ratios that are less than 0.2%, which in a fund like the Vanguard 500 that has returned over 12% over its history is really a tiny amount.

Third, the “success” of mutual funds is skewed by survivorship bias. Well, you aren’t investing in the entire offering of an investment house, so anyone that mentions survivorship bias is repeating talking points. It’s trivial to avoid survivorship bias by doing a bit of research; just find out what the numbers are on the fund you’re interested in and ignore such wide statistics.

Lastly, funds are marketed like anything else – and you pay for that marketing. Again, just do a bit of research and avoid funds that charge 12b-1 fees. Look at discount brokers and investment houses who don’t dump cash into advertising, like Vanguard, for instance.

In short, most of the big arguments against funds either have a good counterargument or can be avoided with some simple research.

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4 thoughts on “Making The Case Against Mutual Funds – And Breaking It

  1. I think a more important thing to note with regards to your “skewed success” comment is that almost all actively-managed funds fail to beat (or match…) the market over long times.

    This gives even more weight to the “buy index funds” theory

  2. Something I haven’t seen emphasized enough is that an index fund–while it may not follow a single stock–certainly follows the market.

    And the market is going to dip, spike, correct, go on runs, run out of gas, sputter, dip some more, return, make someone else rich, etc.

    Investing in the market is a long-term investment on the bet that the markets in which you are invested will prosper in the long run. Be careful to treat it as such.

  3. I had a lot of money tied up in mutual funds and reinvested the dividends. They did very well. As competition between funds became tougher I found that my funds traded a lot and left me with a lot of capital gains. I found that I was writing a huge tax check in April for these gains and didn’t think I was getting a real benefit from them.

  4. i went to a workshop today and the advisor was against mutual funds. i had made a big investment in heebner’s cgm focus fund even with the high turnover. ben stein says my stocks did poorly in 2007 but my mutual funds did okay. my theoryis with stocks you can win big or lose big and with mutua funds that is limited on both side.look at the wsj’s top stocks and see how much they arew down and then take anymutual fund, down less. so in a bad year mutual funds are beter- i think a mixture is best email me if you difer with my comments

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