Mutual funds are very popular for people new to the stock market, as it seems to make perfect sense to leave your money in the hands of an expert. Unfortunately this is not the case, as mutual funds have been found to drastically underperform the average results of the stock market. These average results could be achieved by buying a low-cost passive index fund – or beaten by buying a good performing set of stocks!
One of the main reasons that your money won’t grow as quickly is because of the high fees. Fees vary from fund to fund, but is not uncommon to find a 5% initial charge, 1% annual charge and a performance fee on top. In a market where annual returns over 6% are usually considered good, you can see how all of these charges can eat into your returns!
In addition, if you buy through a private broker instead of an execution-only broker, they will probably charge you an additional 1%, and may have recommended the fund based on a commission from the fund provider.
Private investors have several advantages
You may also think that mutual funds will save you time and avoid big losses in times of recession, but again this is not the case. Mutual funds are vulnerable during volatile periods, because the size of the owned holdings makes it very difficult to find a buyer. Private investors will find it much easier to enter and exit positions due to the smaller volume. Another reason that mutual funds are vulnerable is because of the restrictions that are placed on fund managers. Most companies will only allow their managers to hold up to 10-15% of the funds in cash. Therefore, there is little that a good fund manager can do if they are clever enough to spot that the market is becoming overpriced.
Expectations placed on fund managers prevent them from taking calculated risks, and higher-risk shares tend to outperform conservative strategies over time. However, there is little to gain and a lot to lose for a fund manager who could lose his job if he makes a big slip.
Fund managers are answerable to a company board, which should be a useful safeguard but instead leads to a herd mentality. For example, a fund manager may be pressured to buy a popular share, and even if he believes his judgement is superior he has little to gain from going against the current. This herd mentality can give private investors good buying opportunities as the institutions cause big drops in prices.
Index funds and stocks perform better
Index funds (also known as tracker funds) have become more popular because of the lower fees, but personally I prefer shares as they give me the chance to try and beat the market.
One issue with index funds is how they rebalance. It will sell the holdings of companies if it does badly and buy if the price goes up to reflect their size in the index. This means that you are always buying high and selling low. Index funds are definitely a better option than mutual funds, but I prefer to invest in good quality shares and hold for the long haul.