Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Five Scary Aspects Of Mutual Fund Investing To Avoid

Summary

  • Mutual funds can be a great way to simplify investing and properly diversify your portfolio.
  • Minimizing various mutual fees will help increase your returns in the long run.
  • Doing your due diligence on leverage and concentration issues with your fund can help ensure that you are not taking any unnecessary risks.

As Halloween is fast approaching, I wanted to take now as an opportunity to review some of the scary aspects of mutual fund investing to avoid so that the only scary thing you have to worry about is the haunted house or, if you are in my situation, the crazy couples costume your wife is trying to talk you into wearing with her. Avoiding these common mistakes will allow your money to grow much quicker through the power of compounding and leave you much better off in the long term.

1. Load Fees

Mutual fund loads are sales fees or commissions that go to fund the marketing and selling of the fund, with some/all of this fee going to the broker or investment advisor with whom you buy the fund in the form of a yearly kickback. There has been no substantial proof whatsoever that the funds with loads perform better than those without the extra fee. A 2003 study by Craig Israelson of mutual fund performance between 2000-2002 actually showed that the funds with no load performed better than those with a load. These loads can be split into 2 main categories: front loads and back loads. A front-end load is a load fee that is charged right when an investor enters fund, typically in the 3-6% range. For instance, if you had $10,000 to put in a fund with a 5% front-end load, you would have to pay a $500 fee up front such that you only would have $9,500 once you began your investment in the fund. While in my research I found hundreds of funds of with a front load of 5.75%, I even found a fund with a front load north of 8% that it would certainly be advisable to avoid (Transamerica US Growth Class C (MUTF:TWMTX)).

A back-end load is a load fee that you have to pay when you would like withdraw your money from the fund. Contingent deferred sales loads ((CDSLs)), a common form of back loads, are typically structured so what you would have to pay if you were to exit the fund decreases as you hold the fund for a longer period of time, with the fund owner typically not having to pay a back load fee for money withdrawal after a defined period of five or ten years. While this initial description makes it sound like this is a fee that long-term investors could be able to avoid, as the projected back load for money withdrawal decreases over time, the investor is often paying this back load fee through an annual marketing fee called a 12b-1 fee of up to 1%. For instance, a common example would be a fund with a 5% back load that decreases 1% for every year you own the fund, but you actually end up paying for that 1% decrease through a yearly 1% 12b-1 fee. There are hundreds of funds with a back load of 5.5%. To avoid this and all of its complicated aspects, my advice would be to simply avoid funds with back loads all together as they can take a large portion off of your return.

2. High Expense Ratios

Expense ratios are fees charged to support the operations of the fund, expressed in terms of the percent an investor would pay based on the size of an investment. Expense ratios include 12b-1 fees discussed previously, administrative fees, management fees, general operational costs, and any other miscellaneous expenses. The ratio is determined by dividing the sum of all the costs listed above by the total assets under management. Expense ratios vary significantly, but it should be relatively easy to find a fund with small fees as low-cost fund providers like Vanguard charge very minimal expense ratios. While it is ideal to find a fund with an expense ratio of 0.2% or less or order to minimize costs, it is reasonable to pay up to 0.5%, especially if you are looking for a fund that has a specific specialty such as investing in small cap stocks or stocks in a specific sector. Many mutual funds geared at investing in Master Limited Partnerships ((MLPs)) can have especially high expense ratios due to specific tax rules and deferred tax liabilities, and I would recommend consulting your tax advisor before considering any sort of investment in these. Other funds I noted with high expense ratios that it would likely be advisable to avoid include:

Name

Ticker

Expense Ratio

Front Load Fee

TFS Market Neutral

(MUTF:TFSMX)

8.13%

0%

Pacific Advisors Government Securities

(MUTF:PGGCX)

6.82%

0%

Saratoga Financial Service C

(MUTF:SFPCX)

6.80%

1%

3. High Turnover (and Therefore High Capital Gains)

Mutual funds with a high turnover can have a significant and unexpected effect on your tax bill. As mutual funds choose to sell positions to fund withdrawals or to reallocate assets to new investments, capital gains are harvested if the positions have gone up in value since the fund purchased it. Due to the laws regulating mutual funds, these capital gains that are harvested are passed on to the fund holders though dividends at the end of the year. While the funds are able to harvest as many gains as they would like with their reported performance numbers not affected by these tax liabilities, investors are forced to pay taxes on the dividends at the capital gains rate (and not the lower dividend tax rate), even though they didn't sell any shares of the fund. In the case of the dividends due to fund withdrawals, the remaining holders of the mutual fund are essentially stuck paying the taxes for the people that sold out of the fund. Per the Securities and Exchange Commission (SEC), on average, more than 2.5% of fund performance is lost every year due to taxes, with the least tax-efficient funds causing a 5.6% hit to performance due to taxes. Given these dividends taxed at a high rate, it is highly advisable to avoid buying mutual funds near year-end as you may receive a dividend for capital gains that you did not even experience since you just recently became an investor in the fund.

4. Issues with Leverage

Some funds that you may think are standard vanilla funds may actually use leverage without you knowing, providing a nasty surprise when you open your statement to see your fund down 17% when the benchmark is only down 10%. PIMCO is a prime example of a company that often uses leverage in funds even though you might not expect it by looking at the name of the fund. To avoid this type of scary surprise, make sure you do your due diligence when investing in a fund by reading the prospectus and checking out the asset allocation breakdown on Morningstar.

5. Issues with Concentration

Investors typically look to buy mutual funds to find a way to get broad exposure to the market or a specific area of the market with just one fund. Many funds are often much more concentrated in a few stock than one might expect though, adding a layer of risk for investors. Funds are required to identify themselves as either non-diversified or diversified with diversified funds typically not having more than 5% of assets in the securities of a single issuer. Even if a fund declares itself as diversified, it is still important to do your due diligence. For instance, the Fidelity Contrafund (MUTF:FCNTX) is currently 3.6% Google A shares and 3.6% Google C shares totaling 7.2% in Google stock. The fund also recently had an Apple position, which was over the 5% threshold, but it has since been reduced. The non-diversified group of mutual funds has more extreme examples of stock concentrations. A few that I have identified are shown below:

Name

Ticker

Stock

% of Fund

Fairholme Fund

(MUTF:FAIRX)

American International Group (NYSE:AIG) and Warrants

49.22%

Matthew 25 Fund

(MUTF:MXXVX)

Apple (NASDAQ:AAPL)

14.93%

Voya Corporate Leaders Trust B

(MUTF:LEXCX)

Union Pacific (NYSE:UNP)

13.67%

Matthew 25 Fund firm founder Mark Mulholland even noted, "the only reason you diversify is to reduce risk and the only reason you concentrate is to increase return." While funds in these riskier funds with concentrated positions has been growing, a recent Reuters article noted that 80% of concentrated funds post performance figures in the bottom half of their peer groups. It is also important to check the sector weights when doing due diligence on a fund to ensure that the fund is not overly concentrated in a fund that could significantly underperform in certain market conditions.

Conclusion:

Mutual funds are a good way to simply the investment process and have proper diversification. Make sure to consider these five aspects of a mutual fund when doing you due diligence in order to avoid a scary surprise in regards to performance, fees, or your tax liability when opening a future statement.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.