The "Smart Money" magazine has an article in every issue called "10 things .... won't tell you". Being their long term subscriber, I cannot recall them doing an article on Mutual Funds. This is understandable - after all, those magazines generate a lot of their income from the Mutual Funds' ads, so it might be only natural they don't want to cut a branch of a tree they are sitting on. But I don't have that limitation; this is why you are reading this article.
Mutual Funds are a huge industry. They want you to believe that your money is safe in their hands. The truth is very much different.
Let's first examine few interesting facts.
Here is the list of the ten largest stocks by market cap:
- Exxon Mobil (XOM)
- Apple (AAPL)
- Microsoft (MSFT)
- International Business Machines (IBM)
- Chevron (CVX)
- Google (GOOG)
- General Electric (GE)
- Wal-Mart Stores (WMT)
- Berkshire Hathaway (BRK.B)
- Johnson & Johnson (JNJ)
Looking at most large US Mutual Funds, you will find out that most of them have the same stocks as their Top holdings. Names like Exxon Mobil, Apple and Microsoft will repeat themselves consistently. Like they say, "you cannot get fired for owning Microsoft."
Now let's go to our list.
- Mutual Funds typically charge Purchase, Redemption, Exchange and Management fees, regardless of the performance. You can expect to pay 1.5-2% of your total assets every year, no matter how the fund performed.
- The goal of most Mutual Funds is to beat the index, not to make you money. That means that if in 2008 the S&P 500 index lost 38% and your Mutual Fund lost "only" 35%, it has achieved its goal and the Manager will get his bonus.
- Most of the Mutual Funds (70-80% according to some sources) don't even reach that goal of beating the market. The explanation is very simple - they are the market. If a class has 40 students, by definition 20 of them will be above average and 20 below. Excluding the shining starts and the absolute dogs, most of the funds will have performance matching the appropriate index with margin of 3-4% below or above. That's before fees. Include the fees - and you see how 70-80% of them slip below the average.
- Mutual Funds cannot perform short selling. So even if the Manager has a bearish outlook on a certain stock or the market, he must stay long.
- Mutual Funds cannot trade options, futures or currencies.
- Mutual Funds cannot trade precious metals.
- Mutual Funds are not allowed to trade on margin.
- The maximum investment any fund in any single enterprise shall not exceed ten percent (10%) of the fund's net asset value.
- For liquidity purposes, at least 10% of all funds shall be invested in liquid/semi-liquid assets such as Treasury notes or bills, BSP Certificates of Indebtedness, and other government securities or bonds.
- Many funds cannot own stocks trading below $5. This rule is one of the most ridiculous. They can own Citigroup (C) which made a 1:10 reverse split (and is worth now less than $3 pre-split) but cannot own Bank of America (BAC) when it dipped below $5?
Source: Mutual Funds Investing Restrictions Prescribed by SEC. I'm not sure if those restrictions apply to all funds, but definitely to most of them.
So what are your options if you agree that Mutual Funds are not the way to go?
- Sell all your Mutual Funds.
- If you want to invest in something similar, buy a few ETFs for a fraction of a cost (ETF typical management fee is around 0.2-02.3% per year).
- If you want to have some individual stocks, there is nothing wrong to have a diversified portfolio of 7-10 stocks in different sectors.
- You can buy some of your favorite stocks at discount using the naked puts selling strategy.
- If you want to be more aggressive, you can substitute some stocks in your portfolio with DITM (Deep In The Money) LEAPS.
Whatever you do, I strongly recommend buying some protection such as long term puts. If the markets take a dip again like in 2000 or 2008, no stock will be safe.
Personally, I don't own any stocks. My whole portfolio is options. I described in my article "My Investment Strategy For 2012" how such portfolio can be constructed. This approach is not for everyone, but if managed properly, it can be much less risky than holding stocks or Mutual Funds.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.