Chapter 6. Why Should I Be Concerned About My Mutual Funds?

We have seen that mutual funds offer several potential advantages as an investment alternative, and that investors have endorsed the concept heartily, particularly in the last few years . They have voted with their checkbooks, clearly saying they want to hold mutual funds as a way to build financial wealth. The number of mutual funds available expanded dramatically in the 1990s, so one would assume there must be a demand for them. Therefore, is it really necessary for you to be concerned about your mutual funds?

First of all, of course there are problems and issues that investors need to be aware of. Articles critical of mutual fund performance and practices are appearing more regularly. In 2000, for example, BusinessWeek ran an article titled "Mutual Funds: What's Wrong." When such well-known magazines run articles such as this, it serves as a good indication that it is time to sit up and take notice.

Consider the title of a column by a prominent columnist in a well-known financial magazine that appeared in the same issue as the magazine's Mutual Fund Guide for 2001: "I Hate Funds." ^[1] This is only one of many examples that can be cited, and articles critical of funds are appearing much more regularly now.

^[1] See Kenneth L. Fisher, "I Hate Funds," Forbes , August 20, 2001, p. 170.

Most investors eventually realize that investing involves an ongoing, ever-present trade-off between expected return and risk. If you want to earn a larger expected return, you must assume more risk. Clearly, investors purchase equity mutual funds because they expect the returns to be larger than those earned in a money market fund. However, they must, if they are realistic, acknowledge that the risk is also larger.

Insights

The issue of risk does not pertain only to mutual funds and therefore is not a problem exclusive to owning mutual funds. All investment decisions involve risk ”it is the opposite side of the coin from return, and the two should always go together in the investor's mind. Direct investing involves the same risks. Mutual funds, after all, act as an intermediary, simply doing for investors what they could in principle do for themselves. However, funds might perform the investing activity better than investors doing it themselves , they are more convenient , and they offer several potential advantages such as record keeping and acting as fiduciaries for retirement funds.

As we saw in Chapter 5, investors presumably purchase mutual funds because of the potential advantages they offer. (Of course, people often succumb to the relentless marketing pressures of investment companies, financial advisors, and brokers .) Therefore, it is valid to ask about the downside of some of these potential advantages: Are the advantages really as good as they appear to be, and what are the limitations? Are investors misled about the advantages of mutual funds, intentionally or not?

As we shall see in the following chapters, mutual funds have their problems as well as their strengths. Some are better recognized than others. Some are unavoidable, dictated by existing regulations. None of these limitations are fatal per se, as evidenced by the tremendous growth in mutual fund assets and the widespread ownership of them. Left unchecked, however, some of these problems can be quite detrimental to the financial health of mutual fund owners .

Owners of mutual fund shares and potential investors in mutual funds should at least be aware of the problems that could exist. Ideally, they should fully consider some of the alternatives to mutual fund investing.

Of course, problems exist in direct investing, where investors make their own decisions and manage their own portfolios. Direct investing requires time to research the possibilities, carry out the transactions, do the record keeping, and so forth. Horror stories abound about brokers churning clients ' accounts, accounting lapses (who can forget Enron?), insider trading scandals, and investing scams.

The critical point is that there are two sides of the coin. Mutual funds offer numerous potential advantages, have enjoyed great success, and will continue to be a major player in the future for investors. However, investors must carefully examine the problems and limitations that can occur with mutual funds. Then, and only then, can they weigh the pros and cons of ownership. Then, and only then, can they hope to deal with some of the problems identified here ”for example, large taxable distributions in years when the value of the fund's shares declines sharply.

It may well be that for many investors the advantages are greater than the disadvantages; therefore, they should continue with their mutual fund investments. Others will discover that the problems are larger and more extensive than they realized, and in many cases are not going away absent a change in legislation or prevailing industry practices. You must decide for yourself which group you are in.

An analysis of the pros and cons of using mutual funds as the foundation of an investment strategy has taken on more significance recently for at least two reasons. First, the limitations of mutual funds have become more apparent to many investors. Investors are increasingly aware of these limitations, and they are being talked up more and more in the popular press. Mutual funds are being much more critically examined in the media today.

A good example of recognizing the pros and cons is what happened in 2000 when the market suffered its first decline in several years. At the same time a number of funds made large capital gains distributions as a result of big gains in 1999. When investors went to pay their 2000 taxes in 2001, they found themselves facing significant tax liabilities at the same time there was a sharp decline in the price of their fund shares. Investors had to face the fact that their shares had declined in value by perhaps 25 percent, 40 percent, or more, but nevertheless they had received large distributions from the mutual fund on which they now owed taxes.

The second reason it matters more now to examine whether owning mutual funds is your best strategy is that viable alternatives have emerged for investors. As long as mutual funds were the only, or perhaps the most viable , game in town, it was a moot point to argue about some of their inherent problems. Despite any problems, funds clearly offered a readily available investment opportunity for the average investor to build wealth over time. They had a long, illustrious history, they had track records, and investors were familiar with them.

In the past, if you did not want to go the mutual fund route, your choices were very limited. You could always do direct investing, but many people do not have the necessary funds, time, and expertise to do this. You could purchase an annuity product, but the costs are quite high with this alternative. An investor's alternatives to mutual funds were scarce until recently. Now the situation has changed, and investors have several new alternatives that can be directly substituted for mutual fund ownership.

What if you said this: "I clearly understand the need to diversify, and I will, but I would like to be able to target my investments to certain sectors that I think will be important in the coming years. Biotech is a good example of what I have in mind. Can I accomplish this without building a portfolio myself , and without trying to determine if some mutual fund will let me accomplish this objective?"

What if the response is this: "You can now easily achieve targeted diversification, concentrating on certain sectors or investing styles while still holding a portfolio that is diversified. You can easily accomplish this without mutual funds."

What if you said this: "I have a number of tax problems in most years, and I need to be able to control the timing of any capital gains distributions, and even recognize some losses on positions when it would be favorable for me to do so. Mutual funds seem to be a problem in this regard, so what can I do?"

What if the response was this: "There are now alternatives available that will allow you to manage the timing of your capital gains distributions so that you can take them in a year that is more favorable to your situation. You can sell positions that have losses and net these losses against other gains. You can be in much better control of your tax situation."