For its first fifty years, the mutual fund industry enjoyed quiet and slow but steady growth. Funds were managed by serious investment professionals and were sold to long-term investors by brokers. By the 1970’s the industry had reached sufficient size and diversity to weather the prolonged bear market.
The 1980’s and 1990’s were the heydays of mutual funds. Personal retirement accounts, no-load funds, 401k’s, index funds and a long bull market spurred exponential growth and made mutual funds the vehicle of choice for investors. Sales practices became more aggressive, and it seemed that simply throwing a fund into the marketplace would attract assets.
The collapse of the technology bubble tarnished the image of mutual funds and revealed significant problems. Trading scandals and unethical sales arrangements surfaced, and poorly diversified investors suffered major losses. Just as mutual funds came under fire, a new challenger for the allegiance of individual investors appeared in the form of exchange-traded funds, or ETF’s, and hedge funds captured the attention of wealthy and institutional investors.
Consider a Forbes article last fall with the headline “Mutual Funds Stink”, which extolled the virtues of hedge funds and buying out-of-favor stocks instead of mutual funds. In an interview aired on NPR, the head of Yale University’s endowment offered lengthy criticism of mutual funds and their conflicts of interest. After jumping into the fund business in attempts to create “one-stop” financial shopping for their customers, banks, brokerage houses ands insurance companies are fleeing fund management. Merrill Lynch, Citigroup, Northwestern Mutual and First Tennessee Bank are among those who have sold their in-house mutual funds. In addition to stiff competition, these firms faced increased compliance and marketing costs and pressure to cut their fees.
Other pundits focus on the legitimate problems of the average mutual fund – performance that lags market indices, high turnover (buying and selling of securities) that increases risk and hidden costs, and high operating costs and investment management that have not gone down with economies of scale as funds have grown larger. The disregard with which funds treat their investors is ironic, since mutual funds are by definition owned by those very same investors.
To base an assessment of the entire fund industry on only its problems, however, is to overlook the many funds that do serve investors well, and even fund critics acknowledge the potential advantages of well-run funds. No-load funds are inherently more cost-effective since they have no sales charges built in. Index funds offer exposure to specific market segments, and since they have low turnover in their investment holdings they are also tax-efficient. Funds run by mutual fund companies rather than financial conglomerates tend to be more investor-oriented, and paying attention to fund turnover and performance over a number of years will help weed out funds that are riding short-term performance. Determining an asset allocation that fits your goals and risk tolerance and finding the best funds that meet that allocation is far more productive than “chasing performance” by buying the best-performing funds of the last year. Finally, revisit both your allocation and fund selection at regular intervals, but resist the urge to rapidly move in and out of funds.
As the current darlings of investors, ETF’s offer many of the advantages of traditional mutual funds – diversification, index investing and low costs. Since they trade like a stock they also allow investors to use trading techniques like options and stop loss orders that are not available with mutual funds. In fact, ETF’s are superior for investors who want to take advantage of those trading techniques, and particularly for short-term traders.
But the vast majority of investors are not short-term traders, and most of those short-term traders would be far better off if they gained some patience. It is of far greater benefit to abandon high-cost, poor-performing funds for index funds and other low-cost, consistently performing funds. Once investors have adopted that approach, the further advantage offered by ETF’s, although the subject of much discussion and many articles, is marginal.
As ETF’s have rapidly expanded, they have encountered their own criticisms. A major advantage of index funds is that they predictably track their market index, but some new ETF’s track benchmark indices that are very narrowly and uniquely defined and have sometimes performed differently than the benchmark. Another advantage of ETF’s is that they typically do not make capital gains distributions to shareholders, but in 2006 about 6% of ETF’s paid out capital gains compared to only 3% in 2005. Finally, in a recent analysis by Morningstar Inc. for the Wall Street Journal, large low-cost traditional index funds that track broad market indices outperformed comparable ETF’s in 34 of the 40 time periods studied.
All financial and investment products, no matter how common or seemingly straightforward, have features, risks and costs that should be understood by the investor. Moreover, many products are structured for the benefit of the sponsor or the salesperson rather than the client. Mutual funds are not, and never have been, perfect, but when the right funds are used appropriately, they are still an excellent vehicle to reach your goals.