Certified financial planner Wes Moss provides personal finance advice and accessible investment strategies. His guest post appears here weekly.
Mutual funds have traditionally been the vehicle of choice for small investors who don’t have the time or expertise to maintain their own stock portfolio. But mutual funds come with their share of frustrations, including the seemingly high costs and the annoying tendency of this year’s “hot fund” to perform poorly next year.
The Money Matters team recently completed a study of actively managed mutual fund costs. It turns out gripes about expenses are legit – they can indeed be very high. But what stood out is the great disparity between what a fund says it costs and the actual cost.
We studied 35 popular funds. The average published expense ratio was 0.9 percent, but the actual average expenses were around 3.8 percent. That’s nearly five times the figure provided to investors. That level of cost will eat up profits faster than Piranha coming off a diet. No wonder such actively managed funds, including the majority of top-rated funds, end up underperforming after several “hot” years.
One S&P study shows only 5 percent of mutual funds in the top half of performers over a five-year period were able to stay in the top half during the following five years. In other words, 95 percent of “above-average funds,” fell to “below-average” over the next five years. Another report revealed only 6 percent of the large cap funds that achieved a top-25-percent ranking during a five-year period did so again over the next five years.
Costs account for this underperformance. Our Money Matters analysis found mutual fund costs – excluding taxes — averaged almost 3 percent per year. That means the fund manager needs to be 3 percent smarter than the market every year just to break even or match the index. I don’t care where you got your MBA or how much experience you have, that’s nearly impossible.
So, what’s the solution for investors? Control your expenses by using low cost Exchange Traded Funds (ETFs). ETFs allow tremendous diversification within nearly every investment category while eliminating many fees associated with actively managed funds, including (SPY) the S&P 500 index, and Vanguard’s Dividend Appreciation ETF (VIG).
ETFs typically maintain a fairly stable portfolio, which helps reduce their expenses. An ETF that holds 100 stocks will typically change only a handful of holdings in a year. Conversely, actively managed mutual funds routinely have a 100 percent annual turnover in their portfolios.
Bottom line: steer clear of actively managed mutual funds if you can find an ETF to do the same job. Your portfolio is like a bar of soap. The more you mess with it, the less you’ll have.
How are you investing? Do you have mutual funds in your portfolio?
– By Wes Moss, for Atlanta Bargain Hunter