Why I sold Every Mutual Fund I Had

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Mutual funds are one of the biggest scams ever pulled on the average investor.

Despite high fees, over diversification, and decades of staggering underperformance, well-dressed salesmen (“financial professionals” as they call themselves) continue to herd our personal wealth into these abysmal products.

You’ve probably never heard most of what I’m about to tell you. Wall Street has worked hard to make sure that you don’t.

But there are 5 reasons you should never buy another mutual fund.

FEES

The first, and most obvious, is fees. As of 2013, the average mutual fund expense ratio was 1.38%. This is what you pay to the people who manage your money. You won’t get a bill or even see this figure in your annual statement, but it’s there – cooked into your final returns.

For every $100,000 invested, you are paying $1,380 in fees every year – whether the fund made money or not. Some funds offer lower fees while others can be as high as 2.5%, but this is the average.

A percent here or there might not sound like much, especially if you have a small account balance today, but it adds up. The effects of compounding interest are just as effective at wiping out your account as they are at growing it.

If you invested $100,000 in a fund that produced a 10% annual return before expenses and had expenses of 1.5%, in twenty years your money would grow to roughly $497,250. Had the fee been only 0.5% (1 percent lower), you would instead have $608,580.

Think about that for a second. This is your money. You bled, sweat and saved for it. But the fund manager gets more than $110k of it? That’s over 20% of your gains!

There is a line in The Wolf of Wall Street where Matthew McConaughey’s character says, “The name of the game - moving the money from the client's pocket to your pocket.” This pretty much sums up the mutual fund industry.

Now these are just the management fees. If the shares carry a sales load, you could be paying as much as 5.75% up front before your dollars even hit the market. That’s another $5,750 being taken from your $100,000.

And even if you can somehow stomach that, know that over the same twenty years, it would have grown to more than $40,000. Now your trusted financial professional has managed to suck a whopping $150,000 from your retirement account.

There are also 12-b1 fees to consider. If you purchase your mutual fund through a retail broker, there is likely a 0.25% recurring annual fee tacked on. All told, after twenty years of loyalty to your financial advisor, he may very well eat as much as 1/3 of your total gains.

You may be thinking, “Well, I need someone to manage it. I have to diversify. What else am I supposed to do?”

I’m glad you asked.

I have two words for you - index fund.

Index funds, for those who are not familiar, simply track the large stock indexes – most commonly the Dow 30 or S&P 500. Structurally, they are no different than a mutual fund. Investors pool their money and buy shares in the fund which holds a basket of stocks.

But there are two important distinctions that make them a superior choice.

First is the fees. While most mutual funds have fees between 1% and 2%, index funds sport average fees of 0.13%. So instead of that $1,380 you were paying each year to manage your $100k, that number falls to just 130 bucks.

The second reason to favor index funds is performance. It seems counterintuitive that an unmanaged basket of stocks would outperform a Wall Street high rise full of MBAs in three-piece suits, but it’s true. The reason? Over diversification.

Over Diversification

Diversification is important. Unless you really know what you’re doing, putting your entire net worth into two or three companies is a risky move.

For financial advisors, this is one of their favorite sales pitches.

When I worked for JP Morgan, it was part of the rehearsed script when clients came in. We were even issued mouse pads that showed the annual returns of different asset classes so we were always prepared to make the case for a diversified portfolio.

But Wall Street takes it too far. Most mutual funds hold hundreds of stocks. God forbid you buy into one of those terrible “asset allocation” or “target date” funds and you can throw in several hundred if not thousands of bonds as well. These things are funds of funds. As if one mutual wasn’t diversified enough, now you’ve amplified it by a multiple of ten or twenty.

When you own a thousand different stocks and bonds, it is systematically impossible to outperform the market. You ARE the market. You literally own everything. Not only do you simply ride the ebbs and flows of the general market, but you now pay fees on top of fees to do so, all but guaranteeing lackluster performance.

Poor Management

Even the first two arguments don’t convince everyone. Some investors were sold hard. They are firm believers in their fund. They just KNOW that their money is with a unicorn, that one manager who will consistently generate strong returns.

But consider this.

According to S&P Dow Jones Indices' Persistence Scorecard, only 9.8% of the top-performing funds as of September 2012 were in the top quartile through September 2014. In other words, more than 90% of the top-performing funds were no longer near the top two years later.

Stretch out the time frame, and the likelihood of your mutual fund remaining a top performer gets even worse.

The Persistence Scorecard went further by stating that “…less than 1% of large- and mid-cap funds managed to remain in the top quartile at the end of the five-year measurement period." Translation: None of them stay hot for more than a couple years.

According to S&P's SPIVA Scorecard, 86% of U.S. active funds were outperformed by their benchmarks over the past three years.

What are you paying these guys for again?

Herd Mentality

Wall Street is often accused of having a herd mentality, but nowhere is this more prevalent than mutual funds. Unlike hedge funds where managers receive a percentage of the profits, mutuals rely exclusively on management fees – that flat 1.38% you’re paying each and every year.

They are not rewarded for outperforming. They don’t see any extra income for earning you 20% in a year instead of 10%. Any bonuses managers may receive are tied to how they perform against their benchmark.

Because of this, their goal is simple – don’t rock the boat. Keep the fees flowing.

Mutual funds keep a close eye on one another. Their main competition isn’t the market. It’s similar funds at BlackRock, Schwab and Fidelity. The only real fear they have is looking bad compared to your alternatives. They will follow each other off the cliff rather than risk being different and thinking independently.

Loading up on Tesla even though the company makes no money? Well as long as everyone else is doing it.

Fully weighted in social media stocks even though the sector is in a bubble? But Morgan Stanley is doing too!

It’s ridiculous, but this is what passes for “sound financial advice”.

I was a part of this industry for years. There’s a reason I got out.

Cash On Hand

The last and final reason that I hate mutual funds is a requirement known as cash on hand. In order to handle daily redemptions, fund managers are required to keep some portion of the fund assets in cash. On average the cash amount is between 3% and 7%. So for every $1,000 invested, only 950 of those dollars are actually working for you. The other $50 is dead money.

Even if the fund was able to match the index’s performance, it would lag by roughly 5% from not being fully invested.

Furthermore, the average mutual fund investor has terrible timing. Fear and greed are universal emotions that wreck havoc on long-term success in the markets. People couldn’t buy fast enough at the top of the 1999 bubble. Then they sold blindly at the market bottom in 2009.

To meet larger than normal redemptions during times of panic, fund managers are forced to sells stocks at precisely the worst moments to satisfy investors’ craving for safety. Once the dust settles, those same stocks that were sold at fire sale prices must now be repurchased at higher prices.

This can have an adverse affect on returns both by having less fund dollars invested when stocks are cheap and also increasing the cost basis of the fund’s holdings.

Last year Dalbar released its 21st annual Quantitative Analysis of Investor Behavior report. The findings were awful.

In 2014, the average equity mutual fund investor earned 5.50% while the broader market return was 13.69% - an 8.19% margin of underperformance.

And this wasn’t a one-off event. The 20-year annualized S&P return was 9.85% while the average equity mutual fund investor earned just 5.19% - a gap of 4.66%.

All five of these factors played a role. Crippling fees ate away much of the investor gains. Over diversification and poor management left little chance to match benchmark performance. The herd mentality replaced unbiased insight and decision making. And cash on hand requirements made sure to trim any remaining returns.

If you are an active investor, I’m guessing your dollars are nowhere near the mutual fund arena. For passive investors, my advice is simple - invest in a low-cost index fund or a basket of great stocks you can hold for years. You'll almost certainly do better than leaving your money in mutual funds.