You congratulate yourself. You’re a mutual fund picking expert. You’ve been happy with your returns, but the validation you get from seeing your pick publicly confirmed by such a prominent publication is even better.

And then, like clockwork, the fund’s returns start to stall.

What happened?

The ‘mutual’ in mutual fund began to work against you.

One definition of ‘mutual’ – and the one used in the fund industry – is ‘shared interest’.

In this case, you began to ‘share’ the fund’s management with other investors…all those hyperactive folks who read about your fund on the cover of a magazine and bam, next day, moved all their money over there.

Mutual funds have certain rules that they must abide by. One is that they can only have a certain percentage of their assets in any one investment. And as the new money flows into a mutual fund, the manager has to invest all of that new cash.

What does he do? Well, once he exhausts putting money towards his ‘great’ investment picks (the ones you made out on so well on in years past), he has to move down a notch to his ‘really good’ investment picks. Then the ‘good’ ones. Then his “ok” ones. Then the blaze lackadaisical. Or something. The point is that all those new investors can quite literally begin to dilute the performance of your mutual fund.

And this ‘shared’ downside to mutual funds doesn’t come into play just when there’s good news about the fund.

If a fund or even the overall market experiences a short-term downwards blip for whatever reason, the herd investors often run for the hills. This forces that mutual fund manager to liquidate investments to pay out all that cash. And for you, my dear long term investor, this is bad. It’s actually exactly what you don’t want to happen – selling when prices are down. Nobody makes money that way.

So whether good news or bad news, when it comes to mutual funds, you’re often stuck in the same boat as a lot of other investors that you probably wouldn’t want to be with…if you’d only had the choice.

While there are some good funds out there run by true stewards, with a few exceptions, most mutual fund companies long ago abdicated their real fiduciary duties. Mutual funds are, in short, a good idea gone wrong. As John Bogle once said in reference to mutual funds, “The scandal is not what’s illegal. It’s what’s legal.”

Here are ten things all investors should know before investing in mutual funds.

1. Expense ratios don’t tell the true cost.

A mutual fund’s expense ratio represents the cost of owning that fund. The expense ratio is made of numerous different costs and has become the standard way by which funds’ costs are compared. Unfortunately, it does not include all of the costs that are relevant to investors. Expense ratios often understate the true costs – sometimes dramatically.

Expense ratios ignore three key costs to investors – trading commissions, taxes and sales charges.

According to the Investment Company Institute, the average expense ratio for a domestic actively managed fund is 1.46%. That does not include, however, an average of another 0.27% in fees eaten up by trading commissions. Sales charges, or loads, can also cost up to another 5% in fees. A Morningstar study also found that the average mutual fund investor’s after-tax return is almost 2% per year less than the advertised pre-tax return.

In total, the actual costs to mutual fund investors could be an additional 2.3% to 7.3% on top of the stated expense ratio.

That is simply a huge difference.

2. Other investors can hurt your returns.

Mutual funds are giant pools of money. Upon investing, your money is effectively poured into the same pool that contains billion dollar investments from large institutions. In theory, this is a good thing, as it enables small investors to benefit from the cost savings offered to large institutions. In practice, it doesn’t work quite so smoothly.

When large investors want to take cash out of a mutual fund, the fund’s manager may have to make costly and unprofitable trades to quickly raise that cash. For very large funds, the act of selling a fund’s holdings to raise that cash can depress the share prices of those stocks held by investors still in the fund.

To add insult to injury, those investors who don’t cash out will bear the costs of the considerable tweaking a mutual fund needs to do to its pool after large investors leave. The net effect is that the returns of long-term investors are hurt by the decisions of other investors in the fund.

3. Your fund might be playing favorites.

A mutual fund typically accumulates a position in a company by buying shares in increments through a series of transactions. It is up to the mutual fund company to allocate those differently priced shares equitably among all its investors. To constantly allocate the lowest-priced shares to the biggest investors would be unfair to the little guys.

Despite plenty of company policies, it’s apparently hard for some fund companies to treat all investors fairly. After all – remember that little scandal back in 2003?

4. Turnover and taxes can be a real drag.

Turnover is the percentage of a fund’s holdings that change over a year due to buying and selling. The turnover of the average actively managed mutual fund is approximately 85% (or perhaps even higher, as per this post).

That means the average mutual fund holds a stock for just 10 months. That constant buying and selling takes a big toll on returns due to commissions and spreads. In addition, high turnover effectively forces more yearly capital gains taxes onto fund investors, further impacting returns. Turnover and taxes can be the long-term investor’s worst enemies.

5. Beware the closet indexers.

A “closet index” fund charges high fees for a generic portfolio that acts like the broader stock market. In other words, you’re paying unnecessarily high fees. You could buy an index fund for similar returns with much lower fees.

How to spot these funds? The number of stocks held is a good place to start. How much added value can there really be when a fund manager invests your money in the 137th stock in his fund?

6. Fund classes are confusing on purpose.

You may have noticed that many mutual funds come in different classes. Class A shares typically have a heavy upfront sales charge and a low annual fee. Class B shares have a delayed sales charge. Class C shares have low sales charges but high annual fees.

The mutual fund industry loves multi-class structures. It enables them to sell their funds through the widest possible network of brokers. Investors, however, should be wary. Having different fund classes implicitly suggests that one is right for you when in reality, a no-load or index fund likely makes much more sense.

7. Most managers don’t eat their own cooking.

Less than half of all mutual fund managers actually own a single share in the funds that they run. If a fund’s manager does not believe in the fund, or if they are not willing to pay the same costs and taxes as their investors, why would you ever consider investing in that fund?

8. Mutual funds pay their costs with your money.

Inflated commissions, soft dollars, revenue sharing…you might be shocked to learn how funds spend the money you send them to invest. The most outrageous is called a 12b-1 distribution fee, which can range from 0.25% to 1.0% of your assets. This fee is used to pay for marketing, advertising and distribution.

In other words, you are quite literally paying for the ads and commercials your fund runs to try to sell itself. How does this help investors already in the fund? No one seems to know.

9. You may pay taxes after a loss.

The IRS requires mutual funds to distribute capital gains and dividends to its investors. By passing all tax obligations onto the investor, the fund itself is afforded special tax status. But investors may owe taxes on those distributions even if they don’t sell a share – and, surprisingly, even after a decline in value.

So what’s worse than seeing your fund drop by 50% in 2008? Having to pay taxes on that, too.

10. Once a mutual fund has your money, it’s outta there.

The mutual fund industry continues to grow despite effectively ignoring the vast majority of its customers. In the end, most people find it too much trouble to switch funds, and the fund companies know this.

But if you’re fed up with Wall Street, you might be interested in learning more about Spoke Funds. I built my portfolios differently to avoid all of these issues – plus a few more. You can learn more about the portfolios I manage at my firm’s site, IslaInvest.com, and you can learn more about Spoke Funds® here.

And did I leave anything out in the list above?

Update: Ben points out that I may be dramatically underestimating the internal trading/commissions costs of mutual funds as cited above. He says Edelen, Evans, & Kadlac’s 2007 study “Scale Effects in Mutual Fund Performance: The Role of Trading Costs” likely has better data – and they put the costs I estimated to be .25% at 1.44%, instead. Egads.

Highly recommended reading for anyone who invests in mutual funds.

Click the Download link immediately below for the PDF version.

If you have any doubt about the need for reforming the credit rating agencies, and The Great Recession wasn’t evidence enough, I’d highly recommend Michael Lewis’ The Big Short
for some perspective. And after all we just went through, it’s hard to imagine anyone in charge of managing others’ wealth expressing any kind of support for perpetuating the current system.

But then there are the mutual funds. From an article in today’s WSJ (emphasis mine):

Making this tale even stranger than fiction, S&P has said it is ready to give up its special status. The political problem now is that the mutual fund industry is lobbying to maintain the cartel. Both regulators and fund managers have figured out that doing their own analysis to decide what constitutes an “investment-grade” bond is hard work. But if some third party (such as Moody’s) has deemed a bond safe, no one can second-guess the mutual fund for owning it.

To put a finer point on it, the raters give mutual funds a shield from lawsuits if their investments go sour. All the more so because the Senate and House reform bills contain provisions that will make it much easier for plaintiffs attorneys to sue the credit raters. As long as the cartel remains, everyone is covered—except the individual investor, who loses money when the cartel members rate the next Enron as highly as they rated the last one.

The irony is that it’s the individual investors in those funds who are helping to pay for the same lobbying efforts that end up screwing them over.

Sigh. Long live Spoke Funds®.

The Hidden Costs of Mutual Funds

Portfolio managers can rack up steep expenses buying and selling securities, but that burden isn’t reflected in a fund’s standard expense ratio.

How much does it cost you to own a mutual fund? Probably a lot more than you think.

In selecting mutual funds, most investors know to check the expense ratio, the standard measure of how costly a fund is to own. U.S.-stock funds pay an average of 1.31% of assets each year to the portfolio manager and for other operating expenses, according to Morningstar Inc.

But that’s not the real bottom line. There are other costs, not reported in the expense ratio, related to the buying and selling of securities in the portfolio, and those expenses can make a fund two or three times as costly as advertised.

“These trading and transaction costs are very real,” says Stephen Horan, head of professional education content and private wealth at CFA Institute, a nonprofit association of investment professionals. “While it’s very important to look at that expense ratio, it’s just not going to capture” all of the costs, Mr. Horan says.

Read the entire article here. Morningstar’s estimates of the average fund expense ratio in the above is lower than the industry’s own estimates. I compare mutual fund costs to Spoke Fund® costs here. And email me to receive my article “Ten Things You Must Know Before Investing in Mutual Funds.”

Losing Mutual Funds Still Enjoy Big Paydays.
Despite 2008 decline, some fund giants garnered more than $300 million in fees

Many mutual-fund investors suffered heavy losses in 2008, but managers of some of the largest stock funds – including ones that fell roughly 40% in 2008 – gathered hundreds of millions of dollars in fees during that time.

And later on:

[Morningstar analyst] Dolan also suggested that the dollar amount brought in by fees be expressed in terms of total returns delivered by a fund. For example, if a fund’s returns in a year amounted to about $600 million, and it realized $300 million in management fees, investors would have a clear picture of how much fees affected returns.

The entire article is here.

Another former fund-industry chief executive told me this harrowing story: “I sat in on a management meeting where a senior guy said, ‘This fund’s performance is so bad, all the investors must either be dead or dumb. Nobody will object if we raise the fees.’ It became: ‘Let’s raise the fees, just because we can.’ “