We can’t live with them, we can’t live without them. We’re talking about Mutual Funds. When times are good, Mutual Funds do OK. When times are bad, Mutual funds do really bad. That’s our point; mutual funds can be an OK investment or a terrible investment. What gives? In this article, we explore some of the ups and downs of investing in Mutual Funds.
Invest and go to Sleep, Most of the Time.
Mutual funds offer a few but very good advantages. The first is diversification. Mutual Funds invest in many different stocks and depending on the fund you chose they also invest in a variety of bonds. Why is that a good thing? Because nobody can predict the future: there could be times where even the best of companies run into some kind of trouble and the Stock Market usually heavily penalizes such stocks, especially when it comes to earnings. Most companies in the stock market have gone through or will eventually go through a period where they miss earnings expectations and the stock market heavily penalizes those stocks by indiscriminate selling which reduces the price of such stocks.
Therefore, if the mutual fund owns several stocks then the likelihood of all of those stocks loosing value at the same time is pretty slim.
Here’s a Quick example on how simple diversification works: Say the Fund owns 20 stocks. Say 19 stocks do not change in price but one of the stocks loses 100% in value because the company filed for bankruptcy. What is the performance of the Mutual Fund (fees, taxes, etc not included)? The math is: [(19 x 1 + 1 x 0) / 20] – 1 = – 5%. So, instead of losing All of your money, you only lost 5%. Nobody can be happy about losing 5% but when you think of it as not losing 100% then losing 5% doesn’t sound too bad anymore.
The other main advantage of mutual funds is that the fund is managed by professionals. Diversification is great, but for example, if you buy 20 stocks and all of those stocks are from companies that do oil exploration and you have a sudden drop in the oil price, then it doesn’t matter how many stocks you bought, the entire fund will more than likely lose value so you wouldn’t be as diversified as you thought you were.
There’s more to diversification than what we’re writing here but we hope you understand that Mutual funds are great compared to an average investor investing himself in the stock market because mutual funds have the professionals carefully picking securities and striving to make sure that under a normal economy investors won’t lose all their money (nobody can, however, guarantee that).
By the way, diversification works both ways. Under a normal macroeconomic environment (i.e. a period where there are no recessions) an investor shouldn’t lose much money when there are minor hiccups but when things are going smoothly the investor won’t make too much money either.
When the economy is doing good, mutual funds are a convenient way of making money. In general, the country’s Economic wellbeing goes hand in hand with returns in the stock market (you can read more on it in this article What to Expect when Expecting a Recession). Investing in a Mutual Fund during the “good times” can make the investor an acceptable amount of money without keeping an eye on it 24/7 and being able to sleep at night without many worries.
Invest and Don’t go to Sleep, Some of the Time.
When the economy is doing bad (i.e. when there’s a recession), there’s a big chance the mutual funds you own will implode. Of course in hindsight it is always easy to say “I should have done this, or that, etc” but when we live in the present, it’s hard to know when to get in or out of an investment if you’re an average investor.
What about professional money managers who manage Mutual Funds, do they know when to get in and out of the Stock Market? Probably those money managers do have a good sense of when to get in and out of positions or even out of the entire Stock market but the problem is the way diversified mutual funds are designed make them very hard to get in and out of the market.
First, mutual funds have to invest according to their investment policy and the only way to change the investment policy would be to have the shareholders agree to change it… by the time the mutual fund is bleeding money, it would probably be too late to have the shareholders agree to the change, not to mention most shareholders would have bailed out by then. Shareholders getting together to change the investment policy of the fund is almost unheard of.
Regulation wise, diversified mutual funds need to adhere to the 75-5-10 rule which means 75% of the fund money needs to be invested in companies not affiliated to the fund, the fund can’t hold more than 5% of it’s assets in any one stock, and the fund cannot hold more than 10% of any one company shares. Funds manage Billions of dollars; playing by these rules makes it hard, especially with that much money.
And speaking of Billions of Dollars, in the world of investing, having to Manage Billions of Dollars has a whole set of new problems individual investors don’t have. As you probably know, the price of any stock is a result of supply and demand; the reason you see a Bid price and an Ask price is because the system is set up as an Auction. The more shares are bought then the higher the price of the stock will get, the more shares are sold the lower the price of the stock will get. If you are an individual investor and you want to buy shares of company XYZ then you just put your buy order and you’re done.
But if you’re a Mutual fund, putting an order to buy tens of thousands of shares will, artificially, increase the price of the stock. So mutual funds have professional traders whose main job is to acquire or sell stocks over a course of several weeks or months so that the mutual fund can get an acceptable price without artificially inflating prices just by the high volume of shares that it is buying. In fact, this is such a big deal that if anyone knows that the mutual fund is attempting to buy stocks it would be illegal for that person to buy the stock before the mutual fund does because that person would benefit from the artificial gain in stock price.
There’s a bigger problem with Billions of dollars and that’s when it’s time to sell and you have a recession in your hands. As shown in the graph below provided by the Investment Company Institute (ICI), investors tend to sell when things are going very badly (at the worst possible time!). When the fund has Net Redemptions, that is, when people are selling more shares of the Mutual fund than they are buying (which happens often in declining markets), the mutual fund is put in the difficult position of having to decide which assets (i.e. which stocks, bonds, etc) to liquidate when prices are falling, this will decrease the stock price even further. A fund suffering with net redemptions is probably not going to deliver their clients the performance they are seeking and will probably lose substantial value.
As we’ve seen earlier in this article, even the biggest and most popular funds with a relatively conservative objective (i.e. balanced) lost a lot of value in the last recession. You can read more on the different types of funds in our article Investing in Income, Balance, or Growth Portfolios
As you can see, it is very difficult for a mutual fund to get in and out of stocks which we argue makes turning a profit more difficult. When an investor’s holdings tank and he’s losing a lot of money, it’s going to be hard to sleep at night.
Mutual Fund Manager’s Compensation
The last problem with mutual funds, maybe the biggest problem, is that fund managers are paid based on how well the fund they manage does over the short term, compared to other mutual funds. That’s a big Problem. If a mutual fund makes 5% one year and the other mutual funds make say, 8% that same year, then the fund manager is likely to lose his job.
Investment success is built over several years, not just one year. Even Warren Buffet has had bad years. But, since mutual find managers understand their job is tied to short term performance, the will try to buy what everybody else is buying. When times are crazy and crazy financial bubles are forming, these mutual fund managers are still buying expensive stocks that everybody else is buying and many of them know they are buying junk. So, the goals of the mutual fund managers are not lined up with the goals of investors.
Mutual Funds VS Independent Investment Managers
The financial industry is so big and intricate that there is a lot of confusion on who does what. We have a good brief explanation on the differences between a Financial Advisor and an Investment Manager in our article How to Lose Money Investing in the Stock Market.
As discussed previously, the main problem mutual funds have is that it is very difficult for them to get in and out of the market either because of regulation, investment policy, or the shear size of their operations.
An Independent Investment Manager can move in and out of the market in a faster manner. While nobody can claim that they can consistently make money year after year, especially during recessions (and anyone who makes such claims could be a Bernie Madoff), getting out of the market, especially during a recession, can make a huge difference in the amount of money lost. Getting back in is also important, as individual investors still don’t know When is a Good Time to Invest in the market.
Since the investment manager decides when to sell and when to buy, it allows the individual investor to have peace of mind that someone is actually looking and managing her/his portfolio; that portfolio could have mutual funds (but for your sake, we hope not), equities, bonds, etc. Not to mention, investment managers, with the right strategy and client suitability, can make money in declining markets, a flexibility that many other investment types don’t have.
As we’ve seen by the many articles in this website and data provided by researchers, individual investors in average don’t know how and when to get in and out of investments and this can lead to major losses.
