Chapter 28. Why Mutual Funds Can Be the Right Asset

Part 2 considered some of the potential problems with mutual funds, and rightly so, because typically investors are exposed mostly to the good points. The problems are conveniently ignored, particularly by those with a vested interest in doing so ”for example, those selling load funds. Nevertheless, most of us are smart enough to know there are two sides to a story.

Part 3 showed how to be a smart mutual fund investor by dealing with some important issues head on and making good decisions. It is not enough simply to be aware of the potential problems. We must also know how to go about smart investing in mutual funds.

There is much good news about mutual funds. After all, 55 million households with $7 trillion dollars invested in more than 8,300 funds can't be all wrong. Of course, they aren't. Mutual funds have served many individual investors quite well over a lengthy period of time, and will continue to do so. You need to consider exactly how mutual funds serve your interests, but as we now know you also need to ask if some alternative could do it better.

Mutual funds, like other financial assets, allow you to invest your savings, and typically earn, on average, a positive rate of return. The same is true of a certificate of deposit or the purchase of a Treasury bond. As we saw in Chapter 27, the key to building wealth over time is simple: You must set aside some money by deferring consumption, invest it in assets earning positive rates of return, and let the money grow over time, taking advantage of the power of compounding .

To the extent that mutual funds readily facilitate the wealth-building process, they are valuable , and of course this is exactly what they do. They allow investors to easily own one or more portfolios of securities with an overall objective that is more or less what they are seeking, and investors' fortunes rise and fall as the prices of these securities play out over time. If you plan to invest for a long- term period of 20 to 40 years , you can commit your funds to portfolios of common stocks, the asset that historically has had the highest rate of return among the major financial assets.

You could commit to aggressive equity funds, or you could invest in specialized, nondiversified funds that allow you to make a concentrated bet on stocks ”the Janus Twenty Fund, for example. Or you can invest internationally by buying funds that concentrate on other countries .

International diversification is often recommended for investors as part of an overall investment strategy. Time and time again, financial advisors suggest that at least a small portion of an investor's assets be invested in international securities. There are sound reasons for this advice, primarily the potential for larger returns and a reduction in the risk of the portfolio. After all, if domestic diversification is good, international diversification must be better.

It is true that international investing has not paid off in recent years. The U.S. stock markets have generally outperformed foreign markets, particularly in the late 1990s. By some measures, U.S. returns did three to four times better for a recent five-year period than some major measures of foreign stocks. Furthermore, the correlation between U.S. markets and foreign markets has actually gone up in the last few years. To reduce risk, the correlation between these markets would have to go down.

All of this notwithstanding, the advice to diversify internationally is still sound. The situation will turn around at some point, and foreign markets will do better relative to U.S. markets. Diversification benefits will accrue from international investing, and risk reduction benefits will be gained from holding a combination of U.S. and foreign securities.

It typically is difficult, or at least messy, for investors to construct for themselves portfolios concentrating on foreign securities ”in other words, to invest directly in foreign securities. Mutual funds play an important role by making it extremely easy for investors to own foreign securities. In many ways, mutual funds are the only way to go for most investors when it comes to foreign investing. They have the expertise, the products are readily available, the costs are by and large reasonable, and an investor who does business with most of the larger fund families can easily find foreign funds to complement domestic funds within one organization.

Conversely, if you want to play it safe, you can buy a mutual fund holding only Treasury bonds, corporate bonds , or Ginnie Maes. If you are likely to need your funds back in the short run, you can buy money market funds and have a great deal of confidence that the principal will remain at $1 per share. Or you can buy a short-term bond fund, which has a very stable price.

Mutual funds have been around for a long time, and they have track records. Investors can see numerous examples of what any given initial investment would have grown to over time by holding a particular mutual fund. Numerous Web sites provide quick and convenient information about the performance of mutual funds, their costs, their special features, and so forth. As noted in earlier chapters, there is a wealth of information about funds in the popular press. Funds are constantly being rated, discussed, and recommended. Investors searching for advice and recommendations about funds to buy at any point in time will find more information than they can absorb .

The regulation of investment companies has been very successful, with investor interest protected quite well from fraud, gross misconduct , and other problems over a period of more than 60 years. Even mutual fund advertising is regulated to some extent, as is what goes in the prospectus . More disclosures are now being required of investment companies by the SEC. If mutual funds do not play by the basic rules, they will be detected by the SEC, and appropriate actions will be taken.

When investors consider alternatives to mutual funds, they need to ask themselves if the alternatives are as carefully monitored and regulated by the SEC as mutual funds. Mutual funds are not perfect, nor is the regulation. Nevertheless, the situation regarding funds is extremely favorable for investors, and the overall environment has contributed enormously to the success of the industry.

Clearly, mutual funds can, and do, build wealth over time. Sometimes, for various periods of a few years, the results are spectacular. This by and large reflects the asset held ”stocks have performed strongly over many years, and funds holding stocks have also performed well over long periods. Of course, sometimes the results are not pretty to look at as a result of poor decisions made by the fund manager, or as the result of a sharply declining market (e.g., 2000 “2001).

Insights

Mutual funds do a great job of providing diversification for investors, an important characteristic of a portfolio that often is not easily accomplished by investors on their own. By purchasing a diversified mutual fund, investors typically gain instant and adequate diversification. They reduce their risk because they instantly own a portfolio of many stocks, thereby spreading the risk.

The diversification issue is more important than ever. For many years the prevailing belief was that 10 to 20 stocks provided adequate diversification. This also became a mantra among investors: I must diversify, and 10 to 20 stocks will provide adequate diversification. However, recent research has shown that this is not the case.

Although market volatility as a whole has not increased for many years, individual stocks have become more volatile. There is a lengthy explanation for all of this that comes out of the research, but for our purposes that is not important. What is important is that this research indicates that investors probably need 40 to 50 stocks to adequately diversify, and certainly a number substantially beyond the old guidelines.

Because many investors cannot afford to build their own portfolio of 40 to 50 stocks to adequately diversify, the argument for many of them to hold mutual funds becomes stronger. Mutual funds can provide instant and adequate diversification. Thus, for many investors mutual funds can accomplish something ”adequate diversification ”that they cannot easily accomplish for themselves.

As we have seen, funds can make the job of asset allocation easy to accomplish. If an investor decides to place 60 percent of available capital in equities, 30 percent in bonds, and 10 percent in cash equivalents, this can be easily and quickly done by purchasing three mutual funds.

Some of the problems identified in earlier chapters can be overcome without too much trouble. For example, the name and indicated investment style for many funds is quite accurately descriptive. Although style boxes might not tell investors all they need to know, they are still better than relying on the funds themselves to describe what they are doing.

Still other problems can be dealt with by carefully recognizing the inherent problems and then finding effective alternatives. For example, investors can avoid load funds and funds with high operating expenses by simply reading the prospectus, checking Web site information, and so forth. With a reasonable effort and a clear understanding of the issue involved here, investors should be able to sort through the various share classes and choose the one that best suits them.

It is also worthwhile to note that mutual funds can fulfill some differing objectives for investors who wish to accomplish more than simply investing their money. What if you as an investor are keenly interested in trying to make a difference as a citizen, whether it concerns the environment or corporations doing business more ethically? If you own a corporation's stock, you are allowed to make proposals concerning company policy, and vote on issues raised by stockholders . When you have a mutual fund, however, you cede these rights to the managers of the funds, who vote the shares. Generally, they don't tell you how they vote.

Some funds do disclose important information. Domini Social Investments uses the power of shareholders to influence corporations. It makes various proposals to encourage corporations to act more responsibly. Furthermore, Domini now discloses this record by publishing how it votes and why, the first mutual fund company to do so.

Some investor problems that arise with mutual funds are self-inflicted. Many investors simply do not accept the proposition that markets are efficient and that they are unlikely to select the fund or funds that will outperform others over time. They continue to chase the most recent hot funds in the belief that superior performance will continue, and that they can act quickly enough on recent historical performance to benefit. Of course, this issue also applies to investors who build their own portfolios by buying and selling stocks. Many of these investors also continue to chase the hot stock or sector, as the case of technology stocks demonstrated very recently.

Finally, investors must realize that some problems might not be easily solvable. The tax problem, for example, will continue as long as the existing regulations are in place. Funds will distribute their gains, and shareholders will pay taxes on an annual basis if the funds are being held in taxable accounts. Shareholders have no control over the timing of these distributions ”their only recourse if they know such distributions are forthcoming is to sell their fund shares, which of course triggers another taxable event.

When problems such as uncontrollable capital gains distributions are a major issue, investors must exercise more caution, and do more planning. The same is true when costs are too high or are a significant factor affecting the performance of the fund. It becomes even more important to pay attention to the issue of how one can use mutual funds effectively. We consider this issue in the next chapter. Finally, we might need to consider other alternatives as better solutions to some problems.