Seven Reasons to Avoid Managed Mutual Funds

Here are seven reasons to be leery of managed mutual funds.

Poor Performance

Managed mutual funds pay managers and consultants to pick stocks and decide when to buy and sell them. Some managers do an outstanding job and their funds outperform the market or target industry sector. But most managed funds underperform their unmanaged index fund counterparts. Much of the under performance is due to higher fees and some is due to poor stock selection.

High Fees and Sales Charges

All mutual funds charge fees to manage your money and high fees substantially reduce your total returns. Annual fees of one and two percent may seem small but such fees are deceptively large when you compute their arithmetic impact on long-term returns. For more information about how fees reduce you long-term returns read Mutual Fund Fees.

Too Many Funds

There are thousands of managed funds and many hold the same stocks. For example, check a sample of growth funds. You'll see that many of them hold the same stocks and simply package them with different fund names. Why do retail investors need dozens of funds that are essentially the same? Rather than sorting through a tangle of managed mutual funds, spend your time researching individual stocks that might give you large gains.

Turnover and Taxes

Funds that buy and sell stocks regularly leave the investor with capital gains tax liabilities. Or, if prices start to fall and a fund must sell shares to raise money to meet fund redemptions, you can get stuck with a capital gains tax bill. So you pay taxes and your investment is worth less.

Disappearing Funds

Another mutual fund industry ploy is to dissolve a poorly performing or unpopular fund and merge it with other fund. Therefore, you have to decide if you want to own the new fund, which may not resemble the original fund that you bought.

Closet Funds

A closet fund is managed but it has the many of the same stocks included in a index fund and its performance is nearly the same as the index fund it mirrors. The Magellan Fund, a managed fund, mirrors the S&P 500.

Revenue Sharing

The practice of brokerage firms charging mutual funds to sell their funds is called revenue sharing. The brokerage firms benefit from the revenues they glean from the mutual funds and the funds benefit from the preferential treatment that they receive from the brokerage firms. So it could be that you bought a fund that was best for the broker to sell but not one that was best for you to own.

Revenue sharing is legal but often the practice is not fully disclosed to investors. Therefore, be sure to ask your broker about revenue sharing agreements before you purchase a fund.

Summary and Conclusions

Avoid managed mutual funds. Only a few beat their index fund counterparts. Most managed funds charge high fees for lack-luster performance.

If you want to own a diversified mutual fund, buy an index fund. an exchange traded fund or an all-in-one fund.

Updated March 17, 2007.