Top 10 Best Things About Mutual Funds

Started reading Morningstar’s “Fund Spy” last night.

A gift from the nice folks at Morningstar, so thanks.

In it, Morningstar produces a chart with the top 10 best things about mutual funds.

An interesting list. 

I think the stated items are good, but I have problems with the chart itself. It simply lists 10 bullet points that are the “best things about mutual funds.” No caveats, no expansion, nothing that puts things in context for  readers.

I see this all the time when reading investment related articles. If you already understand the topic, you read an article and go, “Yep, that makes sense.” But if you do not understand the subject to begin with, you learn maybe half or a quarter of the truth. I have found that knowing half of what I need to know is often as bad, or worse, than not knowing anything.

That is why my posts generally are quite long. In work, I prefer short communication, straight to the point. But those communications are to a target audience who understand the subjects. In this writing, with some readers who are trying to learn about a topic from scratch, I would rather cover as many sides of an issue as I can. If that means overkill at times, so be it.

So what are the 10 best things about mutual funds?

1. Diversification is better than you can get on your own.

Generally true.

Investors with greater wealth can effectively diversify on their own through stocks, bonds, etc. Smaller investors are usually better off using mutual and exchange traded funds to diversify.

However, not all mutual or exchange traded funds are well diversified.

Some Funds Have Limited Holdings and/or High Concentrations of Certain Investments

If you desire diversification through a large number of holdings or limited concentration of the top 10 holdings, you may not get it in all available funds.

Fairholme (FAIRX) has 19 holdings. Its top 10 investments make up 77% of fund assets. CGM Focus (CGMFX) has 21 holdings and its top 10 investments are 64% of fund assets.

Not the same diversification as an S&P 500 fund with 500 holdings. Or a global fund such as the iShares MSCI ACWI Index (ACWI), with its 1200 investments.

Note though that a portfolio can be diversified with 20 to 30 investments. Not the easiest exercise, but it can be done.

Some Funds Are (Intentionally) Non-Diversified

Some funds are highly concentrated in a specific sector or investment style.

As part of your overall portfolio, they can aid in diversification. But on their own, weak diversification.

For example, First Trust ISE Global Platinum Index (PLTM). It invests only in platinum companies. Perhaps a good piece in one’s total portfolio, but very poor diversification if it is the only investment one owns.

2. There is greater transparency than any other managed account.

Well, that depends on the particular managed account.

I would say that the more assets in your managed account, the greater the transparency.

I have experienced tremendous transparency with personally managed accounts. And I know certain mutual funds where transparency has been an issue.

For example, with most mutual funds, there is a lag period between trading and reporting positions to investors. This can lead to window dressing by the fund manager.

3. They bring great management to individual investors.

Questionable to untrue.

Active management has not been shown to outperform passive investing. So why pay for “great” (and expensive) management that cannot consistently beat index funds?

And fund management is not homogeneous. Fund managers come in many shapes and sizes. Not all are great. And some can only be great when their investment style is in vogue.

Some managers are better than other managers in general. Long term results help identify strong management.

But some managers outperform depending on the type of market, fund size, and if their investment style is doing well in that period. Consider the Morningstar Fund Managers of the Year for 2011. There are a variety of factors that determined who the best fund managers were in 2011. If a few of those factors change in 2012, you likely will see a different group of best managers in 2012.

4. Low-cost funds are the best deal in investing. 

Yes, that is one of the best things about mutual funds.

But what about exchange traded funds?

They are often less expensive than a comparable mutual fund.

5. They enable you to invest outside your area of expertise.

True. No fault with this one.

However, if you do not understand an investment sector, be careful.

If you know little about say precious metals, how can you compare funds, assess holdings within the different funds, and potential entry and exit points?

Diversification is great, but understand to some degree what you invest in.

6. They are easy to compare.

Also true, assuming we are talking mutual funds issued by recognizable fund companies and cover larger market sectors.

Small funds, funds that specialize in niche markets with few direct competitors, or funds that only trade periodically (e.g., monthly), are not always easy to evaluate or compare.

The more bespoke the fund, the harder the comparisons.

7. Audited portfolios make theft nearly impossible.

I think most mutual funds are relatively safe from theft. But not necessarily because the portfolios are audited.

An audit gives some assurance to the users of financial statements, but they are not infallible.

Can you say Enron, Allen Stanford, or Bernie Madoff?

8. You can get in or out every day at net asset value.

Two errors here.

If investing in closed-end mutual funds, you may not buy or sell at net asset value. There might be a premium or discount involved based on supply and demand. The less liquid the investment, the greater the potential spreads.

Not every fund allows investors to buy or sell every day.

If you are in a small fund that is fully invested in equities, it may not have available capital to pay redemptions on a daily basis. Or for pure accounting reasons, the fund decides to only process applications and redemptions bi-weekly or monthly.

As above, the more bespoke the fund, the greater the potential for less liquidity.

If you are investing in typical mutual funds from large fund companies, daily trading at net asset value tends to hold. But if you are investing in offshore funds or funds that invest in illiquid assets, you may have issues.

Always read the prospectus before investing.

Learn about any potential restrictions before you write your cheque.

9. Some have track records that are decades long.

True. But investors need to look at both the fund and the fund manager. That is, the person(s) making investment decisions.

Warren has been the sole fund manager of Buffet Mutual Fund for 20 years. The fund has prospered, consistently finishing each year in the top quartile of the fund’s investment category. Warren is an excellent investor, albeit quite a secretive man who does all his own analysis. He has no team working with him.

Excellent track record over 2 decades. A fund that attracts my interest (and money).

One day, Warren is hit by a car and dies.

Needing new management, but wanting to save some money on management fees, Buffet Mutual Fund hires young Matt straight out of college. Talks a great game, but has no investment experience.

Same fund. 20 years of strong performance. But that performance relates to a manager who is no longer running the fund. The new guy has no experience.

Does it make sense to attribute the same results going forward? No.

Fund management determines performance.

Note that the converse is also true. Warren does not die. He just gets tired of life at Buffet and wants to create his own mutual fund. So he sets up Warren Mutual Fund. The fund has no track record and probably limited assets under management. But the fund is not the one making the investment decisions. A guy with 20 years of success is doing it.

When considering actively managed mutual funds, always look at current management.

As an aside, I prefer active managers – funds, managed accounts, businesses, etc. – that use a team approach. And many do. This reduces key employee risk within the management team.

10. You can invest automatically without paying commissions. 

Maybe. Maybe not.

Some, but not all, fund companies allow for automatic purchases. That is, periodic direct debits from your bank account.

Of those that do, there may be minimum purchase requirements.

And not all funds allow commission-free automatic purchases.

I would also add that sometimes you can purchase commission-free, but you are charged a fee upon redemption. This might be a deferred sales charge or it may be a penalty for selling within a fixed period of time from acquisition.

Always read the fine print before investing in a specific fund.

Conclusion

Most of the time, the 1o best things about mutual funds will generally hold true.

But not all the time.

As you expand your investing horizons, the probability of encountering exceptions is high.

Remember, the more bespoke or unique a fund, the greater possibility of issues.

With any fund, always read the prospectus and related documentation.

Review the fund company, fund management, and fund itself. Compare it to peers and designated benchmarks.

Ensure you know what you are buying before investing your capital.

Then periodically monitor your investment over time.

If you do your homework now, you improve your probability of success in the future.

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