A few times a year, whether in the financial press or from clients and prospective clients, we encounter comments about mutual funds that contain misconceptions. There are three more-frequent misconceptions that I would like to clear up and purge from investors’ memories.
To establish a foundation, it’s essential to understand that a mutual fund, at its core, is a “wrapper,” or an investment structure that allows many individual investors to pool their money to invest in a basket of securities. Instead of buying many individual securities on their own, investors invest in shares of a mutual fund to gain exposure to these securities with one purchase. Buying shares of a mutual fund allows for easier diversification among many securities.
Now, let’s dig into the three most common misconceptions about mutual funds.
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Misconception #1: Mutual funds give investors the opportunity to beat the market.
I can see where this misconception originated since active investment managers predominantly used mutual funds. The mutual fund structure dates back nearly 100 years in the U.S., gaining popularity in the 1970s and 1980s. Historically, mutual funds were investment vehicles accessing active investment strategies where professionals running the funds attempted to beat the market they were compared to.
In the 1970s, the first passive investment S&P 500 index fund was made available to retail investors. It was designed to track the market, not beat it. As the popularity of index investing grew, more passively managed mutual funds came to market.
If you participate in a 401(k) or 403(b) plan through your employer, odds are you are given a list of mutual funds to choose from, and there are likely passively managed/index options available to keep plan expenses low. A mutual fund is just a structure to pool investors, and it is critical to understand the stated investment strategy, the underlying investments and the cost of the funds you are considering, which vary per fund.
Misconception #2: Mutual funds have high expenses.
Many legacy funds have high expenses, including manager fees and commissions, which have dominated this investment vehicle for decades. However, many mutual funds today have low expenses. Over the mutual fund’s long history, commissions and fees were relatively high by today’s standards. Further, most actively managed funds failed to beat their benchmarks’ net of fees, leading to investors looking for other options. The mutual fund wrapper became confused with the cost of the active management of many funds.
A lot has evolved in this structure over the past few decades. Fees have been driven down, and a lot of low-cost passive index replication strategies have been offered in the market using this vehicle.
Mutual funds are available in all types of asset classes ranging from stocks, bonds, commodities, real estate and money market. There are mutual funds that blend stocks and bonds for certain levels of risk appetite and many that give investors access to liquid alternative investment strategies. The expense level will be driven by how the mutual fund is managed and what type of assets it invests in. For example, a U.S. stock mutual fund will likely have different costs than a mutual fund investing in commodities.
Investors should also pay attention to the share classes of a specific mutual fund. In many cases, a fund may have multiple share classes with different expense levels. Investment minimums may apply to getting access to the lowest-cost share classes. One of the largest passive index mutual funds operates with a 0.04% annualized fee, which is an example of not all mutual funds having high expenses.
Misconception #3: Buying mutual funds is an investment strategy.
In many cases, investors will use multiple mutual funds to design a well-diversified portfolio to meet their needs. They may also use mutual funds to access a specific asset class on part of their portfolio and different types of investment vehicles for other parts of the overall strategy. For example, a mutual fund that is managed to passively track the S&P 500 index will invest only in large U.S. publicly traded stocks. That might suit certain investors who are comfortable with their entire investment portfolio moving up and down with that particular index.
However, investors who may not need to or be able to tolerate that level of price volatility may end up adding other investment strategies to their portfolio to balance out their stock exposure. They may end up adding an investment allocation to mutual funds that invest in bonds or owning the bonds directly if that is better for the specific investor.
While we discussed three common misconceptions about mutual funds, some of this also applies to a more modern pooled structure called exchange-traded funds (ETFs). These, too, can come with different types of investment strategies and a range of costs. However, investors have different misconceptions about ETFs; many believe they are all low-cost and better than mutual funds.
In some respects, ETFs come with more advantages than mutual funds. For example, being able to trade them throughout the day, certain asset classes are more tax efficient in this wrapper than in a mutual fund, and it is possible to see all the underlying holdings daily. While this is not an exhaustive list, the main point is you must still research what each invests in and how it manages the strategy.
Not all mutual funds are expensive, and not all ETFs are cheap. Remember, these are just pooled vehicles that allow investors access to a basket of securities with one purchase vs buying all individual securities on their own. A financial adviser can help you navigate these types of investments and determine a strategy for your goals and risk tolerance.
Halbert Hargrove Global Advisors, LLC (“HH”) is an SEC registered investment adviser located in Long Beach, California. Registration does not imply a certain level of skill or training. Additional information about HH, including our registration status, fees, and services can be found at www.halberthargrove.com. This blog is provided for informational purposes only and should not be construed as personalized investment advice. It should not be construed as a solicitation to offer personal securities transactions or provide personalized investment advice. The information provided does not constitute any legal, tax or accounting advice. We recommend that you seek the advice of a qualified attorney and accountant.
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
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