For investors, mutual funds continue to be one of the best ways to build wealth over the long haul. By pooling their money with other investors, portfolios gain powerful diversification benefits and the capacity to own a bunch of stocks or bonds with relatively little initial capital outlay. Add in the ability to dollar-cost average over the longer haul and it is easy to see why mutual funds are still the number one way most retail investors invest.
However, investing in mutual funds isn’t as easy as just picking a fund and sending a check. There are a few issues that investors need to be aware of. By following some simple steps, taking your time and making sure you understand all the nuances, investors can be successful over the longer haul.
Here are seven of the most common pitfalls that investors make when it comes to investing in mutual funds.
The vast bulk of mutual funds happen to be actively managed. That can be a blessing if you happen to choose the right manager at the right time. More often than not, however, last year’s superstar portfolio manager is this year’s dud. The problem is that the mutual fund industry often posts previous time period returns in its advertising, so investors see the superstar manager’s impressive returns and pile in.
However, as they say: “past performance is no guarantee of future results.”
A recent study by McGill University found that by 2006 (before the 2007/2008 crash), only 0.6% worth of fund managers were able to keep-up their “superstar” status and beat the indexes over time. For investors, looking at longer term performance metrics makes more sense than betting on last year’s hotshot manager.
See also How to Read a Mutual Fund Table
Index mutual funds—or those that seek to track a broad stock index like the S&P 500—are awesome tools for building long term wealth. They offer a cheap and passive way to own the entire market. The problem is, many actively managed mutual funds end up being closet index funds as they grow in assets. This is one of the reason why many superstar managers fail.
Investors end up paying more in expenses and costs to basically track the market. If you’re looking to buy a large cap stock mutual fund and its holdings look an awful like the S&P 500, you’re probably paying too much for the fund.
Forgetting to Check Under the Hood
This pitfall ties in with the previous point. You need to actually look at what your fund owns. In addition to weeding-out closet index funds, mutual fund names can be downright confusing or provide little to no insight into what they hold. It’s impossible to tell what the Clipper Fund (CFIMX) owns just by looking at its name. How about the Equinox BlueCrest Systematic Macro (EBCIX)?
Investors must actually open up a prospectus and dig into the fund’s holdings to see how its assets are diversified.
Limitations on What It Can Own
One of the major pitfalls of buying a mutual fund is that most managers are tied to a particular style of investing. A fund’s prospectus clearly outlines what it can or cannot own. The Fidelity Japan (FJPNX) is only going to own Japanese stocks, so you won’t find a company like IBM (IBM) in the fund. That can be problem if there are no “good deals” within the chosen mandate. For example, Japanese stocks spent years underperforming. Investors need to weigh the potential risks and rewards when selecting funds with a narrow focus.
Understanding the Risks
Investing is a constant balance between risks and rewards. Unfortunately, most investors have no idea what kinds of risks affect the mutual funds they own. For example, while all stocks are subject to “market risks,” small-cap stocks have additional issues that the largest blue-chip stocks don’t need to worry about. Owning managed futures comes with its own set of risks. Every prospectus comes with a detailed list of what risks could hurt and hinder the mutual. Investors need to check these and understand how their investment can be affected.
Another huge issue for investors in mutual funds comes down to fees and costs. Too often, mutual funds come layered with sales loads, high expense ratios, 12-b fees and other costs.
Be sure to see our Complete Guide to Mutual Fund Expenses
These expenses can eat up returns over the long haul and cost investors some serious coin. To combat this issue, investors need to compare the expense ratios of alike products – even at the same fund company. For example, the $231 billion PIMCO Total Return Bond Fund comes in several flavors for the same exact fund. Class A shares PTTAX come with a nasty sales load, while Class D shares PTTDX do not. Mutual fund investors have to see if they are getting the best deal or not and save on those costs.
Forgetting About Taxes
One issue that many mutual fund investors tend to forget about is taxes – specifically capital gains taxes. When a mutual fund sells shares of a stock or bond, it generates a capital gain. Those gains are paid out at the end of the year as a distribution and are considered taxable for its investors. Mutual funds with high turnover rates typically generate higher taxable liabilities for their shareholders.
That “tax-drag” could make owning the mutual fund undesirable. While there are ways to avoid or defer taxes—like using an IRA or 401(k)—investors need to consider taxes as part of the planning stages when it comes to selecting a mutual fund.
The Bottom Line
Mutual funds can be a great way to build wealth over the long haul, but they can also be a huge waste of money if investors aren’t careful when doing their research and considering all facets of a mutual fund. Understanding the various pitfalls and issues related to mutual funds will lead to picking better investments. The seven points listed above ought to be taken into consideration when selecting a fund, prior to pulling the “buy” trigger.