The conventional wisdom is that mutual funds are the perfect investment for the small investor. The idea being that a small investor can easily buy them, have instant diversification, and have a professional managing their portfolio.
Since I advocate investing in individual stocks and not mutual funds, I figured it would be a good idea for me to lay out my grievances, so you can decide for yourself if you agree with me or not.
Easy to buy
On the first point, I would agree, mutual funds are easy to buy. But that’s not really sufficient for me to endorse them as a good. Lots of things are easy to buy, including individual stocks.
Instant diversification
On the second point, I would tentatively agree, some mutual funds do provide some diversification. But the root assumption is that diversification is good. It does cushion the blow of large losses, but it also lessens the impact of big wins.
For example, let’s say you had $10,000 to invest a year ago, and you decided to ignore diversification and put it all in Fannie Mae. At this point you would have only about $700 left (7%), and would have lost the other $9,300. That’s pretty painful. If you had diversified, and only put 2% of your portfolio ($200) in Fannie Mae, then you would only have lost $186.
On the flip side, if you had invested that 2% in Wal-Mart, which went up about 36% over the last year, you would have a profit of $72 dollars. Not too exciting. But, if you had invested the whole $10,000, then you have $3600 dollars. Way more exciting.
So diversification is really just a way to dull both the gains and the losses. If you’re going to dull both, why not just avoid investing altogether and just save your way to retirement?
Professional management
This is where my biggest objections are.
It’s all luck
An extremely high amount of the results from the markets can be attributed just to luck. I would highly suggest reading Taleb’s “Fooled By Randomness” to get a more in depth description of this, but I’ll give it a shot here.
If a manager has 5 years of good returns, it doesn’t mean he’s actually a good investor. It’s actually more likely that he just happened to be lucky. There’s so many mutual fund managers out there that many of them are likely to have long winning streaks even if they just flipped a coin to decide what stocks to buy.
Let’s say we start with 10,000 mutual fund managers who use each use a coin toss to decide their purchases. Each year there’s a 50% chance they pick a winner and a 50% chance they pick a loser. So the first year, 5,000 pick a winner, and 5,000 pick a loser. The second year, the 2,500 of those who picked a winner pick another winner, and 2,500 pick a loser. The third year, 1,250 pick winners, then the fourth year 625, and finally the fifth year 312 mutual fund managers have managed to pick winners 5 years in a row, just by chance.
That doesn’t mean that none of the managers have any talent at picking stocks, but it does mean that it’s extremely difficult to tell which ones do have talent and which ones are just on a lucky streak. And it also means that even the ones that do have talent could hit an unlucky streak and not have a good record.
So it’s almost impossible to tell who is a good manager and who is not, and given how much luck affects their performance, it may not even matter.
Conflicting incentives
Mutual funds make money by taking a small percentage of the money that they have under management. These are the fund fees. If a mutual fund does well one year, more investors will give them money because those investors think that means the mutual fund manager knows something (rather than that the mutual fund manager was just lucky).
The more money that a fund manager has to manage the harder it is for him to find good places to invest it. So if a manager only has a few really good ideas, but 10 times the amount of money that he can invest in those ideas, then the other 90% of the money is going to be invested in something less well performing.
So we’ll get the same effect that we saw above with diversification. Even if the manager can make a 50% profit on those good ideas, that’s still only a 5% benefit to each of the investors since that 50% profit is spread over 10 times the money.
So if the manager thinks he can make a 50% profit on only one tenth of the money, then why doesn’t he only take one tenth of the money and reject the other 90%?
The reason is that it doesn’t make sense for him. Since the manager gets paid a percentage of the money he manages, he can get a 900% raise by taking 10 times the money that he can invest well. So there’s no incentive for the manager to stop taking money when he has more than he can profitably manage.
No control
Another objection I have is the lack of control. You can’t control when stocks are bought or sold, and so the tax bills for those buys and sells are going to come whether you wanted them or not. The same for the transaction costs. You’re going to pay the transaction costs whether you think the buying and selling was a good idea or not.
Secrecy
It would be a bad idea for mutual funds to tell everyone what they were buying. If they told everyone they thought a stock was a good buy, then everyone would buy it in anticipation of the mutual fund buying the stock and push the price up.
But since they can’t tell everyone what stocks they are buying, you as the investor in the mutual fund don’t know what is being bought. This actually leads to at least two problems.
The first is that you could be more exposed to a particular stock than you wanted to be. Let’s say you own two mutual funds and both of them think that Google would be a good investment. If they both buy Google, and Google goes down, then you just took twice the damage you were expecting to take from exposure to Google. This is actually one of the dangers of expecting mutual funds to give you instant diversification. In some cases they can hide how not diversified you are.
The second problem is that mutual funds can try to cover their mistakes. Mutual funds do report their holdings, but not frequently. So if a mutual fund knows they have to report their holdings, they can sell any stocks they own that performed badly, and buy the ones that did well. This makes it look like they may have been holding the good stocks all along. However it also means that you the investor had to pay the transaction costs, and now you’re invested in what was the hot stock over the last year. Which means you’ve probably missed all of the upside and now you might be in for a downside slide.
This article on mutual fund window dressing goes into a little more detail.
Paying for what you already have
Since there is so much luck involved in investing, you pretty much already have an equal or better chance to do what the mutual fund manager is doing. And since you likely have a lot less money to manage, you can look for much smaller opportunities to invest in than the large funds could. And of course by investing for yourself, you avoid the fees that the mutual fund would have charged you in the first place.
Doing nothing would be better
I’ve read it quoted in many places that 9 out of 10 mutual fund managers don’t beat the benchmark they are measured against. The benchmark is usually an index fund of some kind. This means that you can beat 90% of the mutual fund managers just by buying an index fund instead of an actively managed fund. And since the index fund doesn’t need a manager, it usually has much lower fees too. Given how much luck can affect a manager’s performance, what are the chances that you could pick the 1 in 10 that is going to do better than the index fund?
My only real objection to index funds is that I don’t like riding down with the rest of the market. I don’t like exposing that much of my portfolio to downside risk because of how painful losses are and how much effort it takes to get back to zero. That’s my main reason for looking at strategies like the No Lose Strategy.
Conclusion
Managed mutual funds are about the worst investment you could make because the incentives are wrong, and there’s way too much luck involved to know what’s really going on. Index funds are definitely better than managed mutual funds, but that doesn’t make them good enough. In the end, I’d avoid funds altogether and stick with individual stocks and options, and make the effort to avoid taking losses as well.
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