The Case Against Open-Ended Mutual Funds

Most individuals who have modest portfolios are invested in open-end mutual funds (OMFs.)  If these investments are inside a 401K or a 503B there is often times not much that can be done about it.  If, however, your portfolio is with a broker you can, and should, move your assets out of open-ended mutual funds and into listed securities.  Additionally, if your employer sponsored plan has a self directed option you should do the same.

As a general rule I dislike OMFs.  For most of my clients I systematically get them out of these investments and put them into investment using securities that are listed on exchanges.  Included among these are closed end  funds, Exchange Traded Funds, stocks, listed Master Limited Partnerships, etc. Why?

No Intra-day Trading

When trading  OMFs the price is set at the end of the day and, regardless of what has happened between the time the order was placed and the close, you get the price you get based on the Net Asset Value of the portfolio.

Impaired Risk Management

It is difficult  to effectively manage risk in mutual funds.  Because they are unlisted securities there is no way to put stops, limits, shorts or options on the positions.  Perhaps it doesn’t seem like a big deal but think of it this way: if you’re trying to get a net average annual return of 8% from your portfolio and the market drops 4% in a day you have a lot of ground to make up just to get to even.  With listed securities there are ways to reduce that risk by applying simple, yet effective, loss mitigation techniques.

Lack of Transparency

Fund companies are only required to disclose their holding on a quarterly basis – and even that can be misleading.  There is no way on any given day to know what assets are held in portfolio.  Funds move in and out of stocks on a regular basis and, in the process, often violate their own investment objectives trying to make up previous losses.  Small cap funds will buy large cap issues on price momentum – or vice versa -  and then roll out of those positions before reporting dates.  If you’ve ever wondered why certain hi-profile stocks seem to bump at the end of the quarter chances are that fund managers are practicing, what’s known in the trade as “window dressing” , to make sure they have certain names on their statements for reporting purposes.

Regulatory Rules Impair Trading

OMFs has tight guidelines as to what tools they can use and how they can employ assets.  Most are required to hold cash at a minimum  (unless it is a MMF.)  Thus, they are required to be fully invested almost all of the time.  That’s fine in a bull market but in times like these it usually means losses.

Expenses

There are fees inside OMFs that always reduce investment returns.   Typical management fees run about 1.25% of the value of the portfolio and, the reason your broker even has an incentive to sell you non-commissioned Class C shares or no-loads is that they get paid 12b-1 fees – or “trails” as we call them. Trails are usually .25%/year and get paid on a quarterly basis to the broker. For most brokers this annuitized income accounts for a significant portion of their income stream for doing little more than putting you into an investment and letting it sit there like a neglected child.  And if your broker is typical they will sell you full-load funds that have front or back end commissions loads ranging from 2% to 4%. Now, I do believe that brokers deserve to make a living but if you have less than about $250,000 in your portfolio it’s pretty likely that your lucky if your broker looks at your portfolio once a quarter. The typical broker has about 600 clients and, knowing from personal experience, it’s impossible to actively manage that size of a book.  So one has to ask the question; what am I paying for?

Do Yourself A Favor

If you invest through a full-priced brokerage house and your Rep is treating your portfolio like a “set-it-and-forget-it” cooking appliance you should move.  It’s likely that you will match their perfomance simply by buying Exchange Traded Funds- with all of the benifits of trading listed securities -  through a discount broker.

This entry was posted on Saturday, April 4th, 2009 at 10:37 am and is filed under Investing. You can follow any responses to this entry through the RSS 2.0 feed.