Mutual Funds: Good or Evil?

Are actively traded mutual funds good investments, given all the alternatives you have like index funds and ETFs?

We are in a golden age of frugality, when many people want bargains. Mutual funds cost more to own than exchange-traded funds, index funds or individual stocks. That being the case, why should anyone buy a mutual fund when they can buy an ETF that charges just a fraction in fees and expenses?

The answer isn’t as clear-cut as some think. Let’s take a look by comparing mutual funds and ETFs.

Most mutual funds have active managers who buy and sell securities based on their own preferences and strategies. An ETF, on the other hand, very seldom trades shares. It buys and holds stocks that make up an index. Since stock indexes typically change once a year (at most), the ETF usually holds its portfolio intact for a year. That means there isn’t much trading going on. And less trading saves you money.

Also, because the index’s make-up is publicly known, the people who run the ETFs don’t need fancy pants (and expensive) fund managers. They don’t need to trade and they don’t need to do research. Taken together, this means ETF investors save a ton of money in lower expenses compared to a mutual fund.

Does this mean only an imbecile would buy an actively traded mutual fund? Not by a long-shot. Believe it or not, there are distinct advantages to owning mutual funds that ETFs can’t match.

1. Talent. The reason that mutual funds are more expensive is they use that money to hire top fund managers and research departments who are (hopefully) worth the cost. Try to hire one of these managers yourself to handle your personal assets. If you do, you will that it’s difficult because they typically only work with people with extremely high account values. For mutual funds, even if you have as little as $100 to invest, you have access to these whiz kids.

2. Performance. While most funds fail to outperform the market, some funds do deliver outsized returns. If you develop a system to identify those funds (and are willing to accept that you won’t get it right every time), there is no reason to settle for ETFs with only average numbers.

Remember, performance is quoted net of mutual fund fees. So when you evaluate mutual fund performance, you can easily compare apples to apples without doing fancy math. What you see is what you get.

Finance professor Terrance Odean of the University of California, Berkeley's Haas School of Business, did a fascinating study several years ago that found consistency in mutual fund outperformance. In other words, funds that do well now tend to continue doing well. Odean’s research found that the typical period of consistently good performance was 13 months. This is important.

If Odean’s study was correct, it indicates that funds can outperform the market but that after a year or so, their superiority wanes. If this is true, it makes the case for watching performance numbers and rebalancing your accounts accordingly. It also makes the case that buy-and-hold investing might be  very risky, and that it could be very smart to buy a fund rather than an ETF at times.

Economic conditions change over time (which might explain why an out of favor fund may come back into favor). Why not allow those mutual fund managers who are in the right place at the right time to make you money?

When the market shifts and those same funds fall out of favor, why not let the market tell you so? As mutual fund performance numbers are net of fund expense, if you invest based on performance, it just doesn’t matter that funds cost more.

When should you not use mutual funds? If you are a buy-and-hold investor, ETFs are likely a better fit.

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Neal Frankle, CFP, is the founder of Wealth Resources Group in Agoura Hill, Calif. His blog is at Wealth Pilgrim.
 
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