I promised last week I would talk about mutual funds this week. A few disclaimers here on my assumptions. They include I am talking about large cap, actively managed mutual funds in taxable accounts. So, when I use the term ‘mutual funds’ know I am talking specifically about this type of scenario. With that, let’s jump into four quick reasons I am not a fan of owning these types of investment products, especially if you are a high-income earner. It is a three-minute read.
- Mutual funds are incredibly tax inefficient. And I am not talking just about normal dividends within your taxable account.
- It is that time of year where mutual funds have to pass along capital gains.
- There is a database I have access to that shows capital gains distributions for these funds. Let’s look at the numbers.
- There are 316 funds in the database. 233 funds have posted estimates on capital gains distributions. 77 funds are doing distributions between 10 and 19%. 17 are kicking out between 20 and 29%. Finally, 6 have reported distributions of over 30%.
- You may think that is great, which it is in a year when the market is up. But it happens in down years too.
- Last year the market was down 18%. Yet over 70% of funds distributed capital gains and the average was 7%. So, you had a down market but still had a massive tax bill. Yuck.
- Mutual funds continue to lag the performance of the stock market, especially as you expand the time frames.
- While most mutual funds fail to beat their index on a one-year basis, it gets worse once you look at how they do over three-, five-, and 10-year periods.
- Once you start getting into longer time measurements, the higher the percentage of mutual funds that underperform their indexes. Last data I saw showed that well over 90% of large cap mutual funds underperformed their indexes on a 10-year basis.
- Again, single years are tough too for them to outperform. 2022 was the 13th year straight Mutual Fund managers as a majority failed to beat their Large Cap index.
- Much of this underperformance comes down to a key reason, which is our next point.
Mutual Funds Are Expensive:
- The title says it all. Mutual funds are still just damn expensive.
- There are data points all over the place here, but one I rely on says the average mutual fund costs about .70% a year. A comparable index fund costs about .10%.
- I won’t do the math for you, but the difference here is how much an actively managed mutual fund has to exceed an index each year to justify its higher cost. And I won’t even try and mention what the after-tax number would be.
Frontrunning with Mutual Funds:
- The final point is more of an ethical one. It comes down to owners and key management personnel of mutual fund companies putting their own interests ahead of the clients.
- Fidelity owners have done this for years where they invest in funds early to get some extra returns just for themselves. They aren’t alone as other fund families have done the same.
- Also, there was a report recently of a Dodge and Cox manager who has been trading his personal account the same way he was managing his fund and he reaped millions as a result.
- And just to be clear with the point above, he was trading in his account before it became public what his fund was doing. I’m not an attorney, but definitely sounds questionable to me.
I will get off the soapbox now. I just want to be clear. I am not against all mutual funds. Sometimes certain ones make sense in certain types of accounts. Again, what I focused on here are large cap stock funds in taxable accounts for high income earners. In my professional opinion, these types of investment products don’t belong in taxable accounts. Unless your goal is to pay more in taxes and fees and also underperform😉