The Mutual Funds We Love to Hate

Question of the week:I'm interested in an actively managed fund that has had decent returns recently and that I think will do well in the future. I know you advocate index funds, but I really want to take advantage of this opportunity. What do you think? --GT, Long Island

Dear GT,

I understand your temptation to chase performance, but I urge you to consider both sides of the coin when contemplating actively managed funds. To give you some perspective, we asked members of the Armchair Millionaire community for their opinions about actively managed funds. Here are some of the comments we heard:

"The law of averages and efficient market theories show that it is very difficult for an actively managed fund to beat an index fund over time. And when you add transaction costs, it's almost impossible." --Jamie

"Active fund managers charge higher fees and in turn, cannot even beat the index most of the time. I'll take the guarantee of keeping up with the index instead of paying fees to have a slim chance of beating it." --Pat L.

"In the end, three things determine your return: performance, taxes and fees. Index funds are totally comparable to actively managed funds on performance and kick butt on tax efficiency and fees. " --Polly T.

My guide describes what I see as of the major pitfalls of actively managed mutual funds.

The Armchair Millionaire Guide to the Drawbacks of Actively Managed Funds

• High expenses. Since fund management fees and expenses are subtracted from the fund's assets, you never really see what you're missing. This makes it easy to ignore the impact these fees have on your return, but it can be significant over time. While every mutual fund has expenses, actively managed funds on average have higher expenses than index funds-sometimes much higher. To find out exactly how expenses affect your return, check out the Security and Exchange Commission's fund cost calculator at www.sec.gov.

• Tax hits. Every year, funds have to distribute capital gains they have realized on stocks they have sold that are not offset by capital losses. If you receive a capital gain, you have to pay taxes on it-even if the fund has had a negative return that year. The SEC has said that more than 2.5 percent of the average stock fund's total return is lost each year to taxes--even more than the amount typically lost to fees. Because index funds have very little turnover of their holdings, they realize few or no capital gains that must be passed on to you.

• Style drift. In search of better investment opportunities, it's not uncommon for fund mangers to stray from the stated investment strategy of their fund. A value fund manager, for example, might start investing in growth stocks when they're hot. Likewise, a small-cap fund might buy some mid- or even large-cap stocks. This can make it nearly impossible for you to achieve the asset allocation you really want. Since index funds are pegged to an index, they won't stray from their original intention.

• Lack of disclosure. You have to know exactly what an actively managed fund owns on any given day. This means that you could easily own the same stock in several different funds, and not know it. It also makes it tough to confirm that the fund is still buying the kinds of stocks it did when you originally invested. Since index funds own the stocks of a particular index, you always know what you own.

THE BOTTOM LINE: When you take everything into account, I believe there's less to love about actively managed funds over index funds. By their nature, index funds are the lowest cost, most tax efficient, most reliable tools for building a long-term portfolio.

Comments

[Al]

Is it possible to become millionaire if you take 20% of your profit in mutual funds and reinvest to another new mutual funds, and do it over and over again?