I get the impression you are very negative on mutual funds. Is this correct? And if so, why?

 

Patty S., 48, is an executive secretary in Hamilton and a growth investor with a $500,000 portfolio. She asks:

Mutual funds do have their place. Years ago, before mutual funds, the small investor didn’t have access to the stock market as that arena was reserved for the wealthy who had portfolios large enough to diversify.

Mutual fund companies recognized that the small investor should be able to access the stock market, thus the mutual fund was born, and it is still a good investment for small investors and special situations. Funds provide proper diversification and professional management with, what some would say, an exorbitant cost of about 2.75 per cent per year, which is not tax deductible.. That equates to about $14,000 a year for your portfolio.

Over a 25-year holding period, that fee will gobble up 24 per cent of your investment, while the foregone earnings eaten up by that fee will devour another 33 per cent, leaving you reaping only 42 per cent of the gain of your fund. Let’s put it another way. You put up the money, you take the risk, and you receive only 42 per cent of the gain?

Proper portfolio management can be found elsewhere for a fraction of that cost.

Over the years investors have flocked to mutual funds, regardless of the size of their portfolios, like seagulls to a fast-food parking lot. Since many investors fail to see that cost really does matter, let’s look at fund performance. The TSE 60 has risen 7.33 per cent per year over the past 10 years. Perusing about 240 mutual funds that have a 10-year history you see that 75 per cent of them have been unable to match that indices performance. In addition, it’s impossible to predict which mutual funds will beat the market indices in any given year.

If you believe The Efficient Market Theory, you know it’s impossible to beat the market since prices already incorporate and reflect all relevant information. The Random Walk Theory states that stocks take a random and unpredictable path and it is impossible to outperform the market without assuming unacceptable risk. Overwhelming academic research here and in the U.S. indicate that over the long term, efforts to select active managers who will outperform the market is a zero sum game and investors are better served by investing in passively managed funds.