Consider Replacing Your Expensive Mutual Funds With ETFs

mutualfundDennis Miller: I came from a generation that believed mutual funds were run by real experts like John Templeton, who did tons of research, made spectacular investments, and allowed the little guy like me to benefit from the results – for a fee, of course. For many years that was true, but our investment team has convinced me that I need to rethink my firmly ingrained beliefs. Let’s take a look behind the curtain.

Most Mutual Funds Cannot Beat the S&P 500

Over the last five years 65.44% of active, large-cap fund managers failed to outperform the S&P 500. Nevertheless, paying management fees to a mutual fund is not always a bad idea. Not all funds are stock funds designed to grow and beat the S&P 500. If you want a fund for specific reasons – like being more defensive or having specific diversifications, or maybe you want a bond mutual fund – then beating the S&P 500 may not be your primary goal. Comparing these types of funds to the S&P 500 misses the point.

If, however, you are investing in a diversified portfolio of equities for growth, then the comparison to the S&P 500 makes sense. It is a tough challenge for a fund manager to not only beat the S&P 500 consistently, but to also beat it by a wide enough margin to cover their management fees. You might just be better off in an ETF like SPY that mirrors the S&P 500 with lower costs to the investor.

This might mean you miss out on a mutual fund that performs better, but it will probably just keep you away from funds that can’t get the job done. Frankly, at this point in life protecting our nest egg trumps reaching for the remote possibility of higher yields from funds that have not performed consistently.

At the same time, when it comes to investing in bonds, a good fund with a low expense ratio makes a lot of sense. A person with $10,000 to invest puts his money at greater risk if he invests all $10,000 in a single bond than he would with a bond fund. First, if he wanted to sell a single bond, he might face some liquidity issues. And second, if there was a default, he could easily lose his entire investment.

The Optimal Way to Diversify

While mutual funds may technically be the optimal way to diversify – assuming they actually perform well – do we really need optimal diversification? Before you say to yourself, “Yes, of course; I want the best,” consider the following comments in the April 2013 issue of Money Forever:

“There is tons of academic research on optimal portfolio size and diversification, and what has been discovered is pretty dumbfounding. With a bunch of math and statistics, you can reduce the risk of your portfolio. Needless to say, it gets complicated.

But there is good news for retail investors. Academics have also found that owning 10 to 25 stocks has just about the same risk-reducing effect as the fancy math-based portfolios.

Depending on the study, the number may be slightly different (10-25), but they all conclude that after a certain point, owning another stock does little to reduce your risk – even if you’re using some impressive formulas. Being a math wiz only reduces your risk a tiny bit more.”

I have a friend who thinks investing in six mutual funds in different sectors keeps him protected. While it may give him some protection, how much does he really need, and is the cost worth it? Each fund lists its top ten holdings, plus it outlines the total number of holdings. Frankly, he could easily have positions in over 1,000 stocks, and he is paying significant fees that put him well beyond the point of diminishing returns. In short, mutual funds and ETFs can provide diversification, but at a certain point, it becomes overkill.

Management Fees Do Matter

A dear friend of mine works with a firm that charges him a management fee to invest his money in a basket of mutual funds. In his case, the funds are bond funds, so it would be unfair to compare the results to the S&P 500. His return last year was 6%, net of fees, which totaled 1.38%.

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