Mutual funds are a fine investment vehicle for smaller pools of assets. They provide diversification that would otherwise be difficult and costly for newer investors or smaller portfolios.
However, for investors with larger amounts to invest, mutual funds become increasingly expensive and inefficient in our opinion. For example, mutual funds can charge up front and ongoing fees. Even so-called “no load” funds have ongoing trading and maintenance expenses. If you have a larger pool of assets, it may make sense to invest in a diversified portfolio of single stocks.
To learn more about some of the possible pitfalls you may encounter as a mutual fund investor, click here.
Investors typically use mutual funds to diversify—a good strategy in theory. But if you have a larger portfolio, mutual funds are often counter-productive in our opinion.
Why? We've found the average mutual fund owns about 120 stocks1__ and with many investors holding multiple mutual funds in an effort to diversify, they could own thousands of individual securities! This is no longer diversification—it is over-diversification.
1Source: Morningstar 4/22/2014
Such a strategy may also result in inadvertent over-concentration in certain sectors or styles. In an attempt to manage risk, mutual fund investors may actually be increasing it.
Moreover, the managers of these funds do not communicate with one another regarding an investor's overall portfolio. One manager may be buying a stock while another sells, causing investors to pay two commissions for no net change in position. Why is the first manager doing the opposite of the second? Who's right?
Mutual funds can be tax inefficient as well. The buying and selling of securities within a fund can't be customized for your tax preferences. And, in years when investors have a loss in the fund, fund managers can still pass capital gains taxes onto fund holders. You can lose money and still have to pay taxes.
To learn more about how to diversify more effectively and efficiently, click here.
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