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Mutual Fund Flaws: Do you know what you own?

A mutual fund is a legal structure in which a large number of widely dispersed, unrelated investors, with sometimes conflicting objectives, pool their money for investing. They were created to offer small investors a method to own a diversified portfolio and enjoy the economies of scale with a modest amount of money. However, in the 21st century, technology and competition can now offer investors more open, liquid and customized alternatives.

John Bogle, founder and retired chairman of The Vanguard Group, had predicted on CNBC on August 21, 2012, that 50% of mutual funds would be gone within the next 15 years. We predict that mutual funds, a trillion dollar industry, will be replaced by more evolved portfolios that feature lower costs, greater flexibility and clarity, and more coherence between the objectives of the asset manager and the investor.

Here’s why.

Internal Drag (High Costs of Investing)

According to Morningstar (2015 Fee Study), the asset-weighted expense ratio for passive funds was just 0.20% in 2014, compared with 0.79% for active funds. However, there are other costs specific to mutual funds that are either not reported on or revealed directly in any way, in other words, they may appear "hidden" to many investors.  The largest category of these is transaction costs with its three components: Commissions, Bid/Ask Spread (A bid-ask spread is the amount by which the ask price exceeds the bid. This is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it), and Market Impact (In financial markets, market impact is the effect that a market participant has when it buys or sells an asset. It is the extent to which the buying or selling moves the price against the buyer or seller, i.e., upward when buying and downward when selling).

If you own mutual funds within an annuity or a 401k plan, you may also burdened with the additional costs of insurance (M&E expense) and 401k administrative costs associated with these ‘tax shelters.’ To keep more of your earnings, there may be other options available. Your financial advisor can provide further information regarding your options.

One Size Fits All Approach

By their nature, mutual funds are a ”one size fits all” strategy as any single mutual fund may have old, young, wealthy, struggling, aggressive and conservative investors who pay the top and bottom tax rates. With so many investment vehicles available today, we believe that simply settling for a mutual fund position may no longer be necessary.

Style Drift

Style drift is the tendency of an investment portfolio manager to alter an investment style over time. In practical terms, most investment strategies change and must adapt through time; however, style drift can become a significant risk for investors if their portfolio’s focus changes too much.

The problem is not only that style drift can alter a portfolio's path, but it can also hurt investors in a way that they didn’t sign up for when they selected a manager and his style.

In our opinion, many fund managers may chase trends and end up venturing into the latest greatest strategy that may only have a temporary ride. In 1998 and 1999, it seemed all a portfolio manager had to do to chase the dotcom boom without investing in Internet companies was to invest in companies that had not yet announced their Internet strategies. However, many started either investing in these companies or the actual headline stocks after the fact. A general rule is if it is a "newest and latest" trend on a magazine cover, a lot of the good things have already occurred.

Perhaps the largest cause of style drift is underperformance. When an investment manager is lagging behind a target or when the portfolio is seeing losses, style drift might be an easy strategy.

Pretend that your investment manager uses the S&P 500** as a benchmark and the portfolio is up only 3% when the S&P is up 16%; this may have occurred because the manager made some poor choices or left too much of the portfolio's assets in cash. A risk is that the manager will start making larger, more focused and concentrated bets, rather than diversified longer-term planning. This situation is unfortunate, but when the pressure to perform becomes too great, the investment manager may be tempted to take greater risks which could have a big impact on individual’s financial goals.

Tax Inefficiency

Your mutual fund investments are commingled with everyone in the fund. The fund’s gains and losses embedded in it could often be realized by a newer shareholder that hasn’t actually realized any gain in his investment. This means you could invest in a mutual fund today; your fund prices goes down due to market conditions and at the end of the year, you could receive a capital gains statement saying your owe taxes from an investment made years prior to owning the fund. This is known as ”buying the distribution.”

If you would like to learn more about how these risks affect you, please contact us

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.  Investing in mutual funds involves risk, including possible loss of principal. Value will fluctuate with market conditions and may not achieve its investment objective.

**The S&P 500 Index is designed to measure performance of the broad domestic economy through 500 stocks representing all major industries.

This material was prepared in part by Dave O'Rourke, SVP EQIS Institutional, Inc.