Why I Don’t Invest in Mutual Funds

For more than four decades I’ve involved myself in investments, including stocks and bonds, real estate, mortgage lending, and variety of enterprises, some of them hard to describe. However, there is one endeavor that I’ve systematically avoided. It is the mutual fund. At the risk of alienating the investment world, I offer the following observation: Mutual funds are not a particularly profitable way to invest. Let me share with you my biases on this subject.

As with most activities, what we get out generally relates to what we put in. Proficiency on the tennis court requires many hours of wielding a racquet. Mastery of an academic subject necessitates study. Similarly, to place your money for favorable return, you must familiarize yourself with the intricacies of each investment. For those of us who make this an active part of our lives, questions must be asked—and astutely answered. If we fail to do so, bad things happen.

This brings us to reality. The fact is, a majority of persons are unable or unwilling to analyze investments. There is something in the human psyche that tends to discourage methodical scrutiny. The average individual prefers to broad-brush most subjects while accepting pronouncements. Thus, if a banker or a broker assures that an offering is acceptable, it’s accepted without deliberation. As implausible as it may seem, this is how most persons conduct their financial lives.

It’s from this premise that the most powerful and profitable marketing tool of the securities industry developed. Since formation in 1924 of the first open-end investment company in the United States, known as the mutual fund, its acceptance by the public has grown to become universal. Quite simply, a mutual fund controls a pool of money provided by its shareholders that it invests in a portfolio of securities selected by the fund’s managers. In recent years they have proliferated like mushrooms, with over fifteen thousand registered funds in existence, and total assets now exceeding $10 trillion. They exist in near-infinite varieties offering almost every conceivable mix of securities. For the potential investor with both limited expertise and assets, this type of investment vehicle seems to meet two important criteria: astute selection of securities and advantageous portfolio diversification. Whatever else you may say about the mutual fund concept, one thing is undeniable: It truly captures the essence of the average citizen’s disdain for financial involvement. Each participant need only exhibit the astuteness demonstrated by loveable Sergeant Hans Schultz of the 1960s “Hogan’s Heroes” TV series, who regularly declared: “I see nothing! I hear nothing! I know nothing!” And in reality the mutual fund was designed so that only one involvement is required by the investor: contribution of money.

Though in theory the mutual fund meets the intended needs, theory and reality do not always coincide. Before describing my fundamental concerns, let me acknowledge that many mutual funds operate satisfactorily, and that large numbers of investors profited handsomely over recent years. Recognize, however, that these favorable results did not necessarily reflect the skill of the fund managers, but rather the consequence of a period during which the major indices posted their greatest sustained rises in history. There is no particular magic involved. These funds merely rise and fall with the general fortunes of the market.

When comparing the mutual funds against direct purchase of corporate stocks, the latter provides the better return. The reason is obvious. The additional overhead costs of the mutual fund operation must be superimposed on the investment. And don’t imagine that these costs are insignificant. Over the years the industry has devised ways to separate the populace from its money. Most managed funds assess “loads,” which are commissions charged to the buyers that run as high as 8½ percent of the purchase price. Although the conventional recommendation is to avoid the load in preference to the no-load funds, many of the no-load funds incorporate equally objectionable fees. These include redemption fees, often known as “back-end loads,” to be paid when the shares are sold. A variation on the redemption fee is a deferred charge when shares are redeemed within a certain number of years, known as a deferred load. Another contrivance approved in 1980 by the Securities and Exchange Commission is known as the 12b-1 plan that permits a fund to confiscate up to 1¼ percent per year of the fund’s assets for marketing purposes. At this rate, a participant in such a no-load fund over ten years contributes 12½ percent of the investment in such fees. You may add to the list of undesirables those funds that debit portions of reinvested interest, dividends, and capital gains, known as reinvestment loads, as well as other less than obvious ways some no-load funds separate client from asset.

To be certain, the lowest management fees are those assessed by index funds, which are an assembled collection of securities whose composition mimics that of a particular market index, such as the Dow Jones Industrials or the Standard & Poor’s 500. As investment analysis and decision-making is not required of the managers, no justification exists for a substantial fee. However, use of the index fund raises a fundamental question: What justification is there for a mix of securities often selected at random? It’s my opinion that the index fund is the logical extension of the know-nothing canon. Not only need the investor disavow knowledge of anything financial, but the same rule pertains to management. An arbitrary set of index funds can then be designed and offered in which there ceases to be any responsibility for performance. Profitability for the fund operators becomes based solely upon the fees that can skimmed from the pot. In this way, the operation of an index fund becomes an exercise in pure marketing.

This gets us to the bottom line. For those of you unwilling to take part in the management of your assets, the mutual fund is your only option—investment by default. For others, who aspire to see their fortunes grow, there is a world of opportunity to be embraced.

Original article here.