Investopedia defines a mutual fund as an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by money managers who invest in the fund’s capital and attempt to produce capital gains and income for the fund’s investors.
One of the main allures to investing in mutual funds is that they are essentially pre-diversified. Rather than needing to be an expert on a particular stock or bond, an investor can utilize a mutual fund due to the broad amount of underlying investments held in the fund. This diversified nature causes mutual funds to often be considered more secure than stocks, but it’s always important to remember past performance is not an indicator of future results and investing in mutual funds involves risk. Mutual funds are also flexible in regards to their investment amounts, which opens up a wide swath of prospective investors. This provides accessibility to investors at all income levels.
While there are plenty of reasons an investor might consider a mutual fund, it’s absolutely crucial that a prospective investor knows the risks as well. While there are endless possibilities in terms of pros and cons, I’ve identified 6 risks mutual fund investors need to know.
No one wants to talk about the enormous sums of money mutual fund companies make, but let’s face it, they are in this to generate a profit. Many companies are stuck in the conundrum of providing performance for investors while also generating a profit for themselves. Mutual fund companies spend a lot of money on advertising in an effort to acquire assets. While I’ll dive into fund expenses later, you’ll notice a correlation between performance and expenses. There’s an old adage that you get what you pay for, but that’s not always true. All of the fees and expenses directly conflict with investor returns.
If you do some research, you’ll notice a lot of mutual funds struggle to provide above-average returns. Most fund managers have a goal to beat the overall market, which can be extremely difficult to do. The individual fund managers are benchmarked against a particular index, which becomes difficult to beat when saddled with high costs. This can lead to what’s known as chasing returns, which can sometimes exacerbate potential losses. Mutual fund companies focus a lot of effort on promoting their flagship funds, such as ones that receive high ratings from a firm like Morningstar. Many investors pour a lot of money into funds simply based on their star rating thinking that they stand a better chance at capital appreciation.
Bond Mutual Funds
I’ve heard many times that an investor has purchased a bond mutual fund for the purpose of safety and income. It’s very important to understand that a bond mutual fund is NOT a bond. If you purchase a 30-year bond, the price sensitivity to interest rate changes declines as the bond gets closer to maturity. If you invest in a bond mutual fund with an average maturity of 30 years, you’re involved in a completely different situation. Bond mutual funds do not have a maturity date, but rather often utilize a fixed average maturity that doesn’t decline. A conservative investor seeking interest income payments might be better suited to utilize an individual bond, but it’s important to investigate the risks you’re willing to take.
Another key aspect that is overlooked in regards to a bond mutual fund is that the fund manager can use leverage to increase its yield. Anytime leverage is involved, this can always increase the investor’s overall risk to their principal. Ratings can only identify funds that have performed well in the past, which absolutely does not predict future results. In fact, this type of behavior is one of the most common mistakes investors make and that is buying high and selling low.
Fees and Expenses
As I noted earlier, fees and expenses directly affect a mutual fund’s performance. According to the Investment Company Institute, the average expense ratio of equity mutual funds was 1.28% in 2016. While this figure has declined over the years, the expense ratio still has a direct impact on overall returns. These expenses are required to be disclosed in the mutual fund’s prospectus.
What can sometimes go overlooked in regards to fees and expenses are some lesser known items such as trading costs, commissions, market impacts and taxes (another risk to discuss later).
Trading costs are associated with all securities transactions and they can increase overall expenses in active mutual funds. The industry sometimes refers to trading costs as the bid/offer spread, which is simply the difference between the price a buyer is willing to pay and the price at which a seller is willing to sell. Mutual fund managers buy and sell securities within a mutual fund and each time they do, they incur trading costs, which are passed along to the mutual fund owner. A telling report in 2013 by Roger Edelen, an associate professor of finance at the University of California, Davis, found that mutual funds’ trading costs were 1.44%. These trading costs are “invisible”, yet can have a significant impact on the return investors ultimately realize.
While commissions to brokers are typically disclosed (yet another risk to discuss), transaction commissions can often go overlooked. While large trade sizes can cause a fund to operate in a low commission structure, the cost is still worth noting as it all adds up as a potential risk to the investor.
Market impacts are likely the most overlooked, yet they could have the potential for the biggest risk in terms of fees and expenses. All institutional investors are afforded concessions in price when they execute large trades. By a fund simply executing a trade of this type, they could move the cost due to the sheer size of shares being sold. If an individual investor were to sell 100 shares of Google stock in the open market, the price won’t move much. However, if a large fund sells 1000 times that (100,000 shares), it could have an impact on the overall share price. This leaves investors vulnerable to a market phenomenon that is 100% out of their control, yet they are fully exposed to.
Confusing or Limited Disclosures
In 2001, the Securities and Exchange Commission (SEC) adopted a rule that prohibited misleading mutual fund names. This rule required that “a fund with a name suggesting that the fund focuses on a particular type of investment (e.g., “stocks” or “bonds”) to invest at least 80% of its assets accordingly.” With that in mind, let’s examine a common mutual fund.
The Income Fund of America is a mutual fund that has an emphasis on income, hence the name. There’s one key point that needs to be addressed right away. There’s absolutely nothing wrong in terms of the above SEC rule. However, the average investor might see a name like that and assume that the fund invests primarily in fixed income instruments. One need not look very far to see that up to 25% of assets can be invested in stocks of companies based outside of the United States and up to 20% of assets in bonds rated below investment grade (BB and below). Again, there’s nothing wrong here and this fund is listed under “equity-income funds”, but many consumers fixate on the name of the fund itself. This underscores the importance of truly knowing what’s held within the mutual fund and not just focusing on the fund name.
Any investment comes with tax implications and mutual funds are no different. As always, please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation. Mutual funds can be inefficient at times in regards to taxation. Remember, a mutual fund is a basket of different shares that the fund manager deems fit given the fund’s objective. This means you are buying a share of an existing company that owns many individual investments and they each have their own tax liabilities.
To avoid paying corporate income taxes on their profits, mutual funds are required to distribute all their net gains to shareholders at least once per year. This income the investor receives is either distributed as a capital gain or dividend distribution. Capital gains distributions are generated when the fund manager sells fund assets for more than they were purchased. Dividend distributions are generated when your fund includes dividend stocks and interest-bearing bonds.
The overlooked aspect of this is that depending on how long your fund has held the assets, the income you receive may be taxed as ordinary income or capital gains. Investors overlook this quite often and it’s a very important risk to understand. Remember that not all capital gains distributions are taxed at the capital gains rates. Unlike when you invest in individual stocks, the applicability of capital gains has nothing to do with how long you have held the mutual fund shares, but rather how long the fund itself has held the underlying assets. Only gains from assets in the fund that have been held for more than a year are taxed at capital gains rate. This is important to know because the difference between your ordinary income tax rate and your capital gains tax rate could be large. The inability to control your individual tax situation can be a headwind for your overall performance.
In the first risk, I noted that the old adage “you get what you pay for” is not always true and this final risk will magnify that statement. There’s zero evidence that if you pay more in fees that you’ll get a better rate of return. It’s crucial to understand mutual fund share classes, as this will tell you the upfront cost of doing business when you invest. There are more than three types of mutual fund share classes, but I’ll focus on the three most common share classes.
Class A shares charge an upfront sales fee that is taken off of your initial investment. If a Class A sales charge is 5% and you invest $5,000 in the mutual fund, you will start with $4,750. This leaves you needing to hold the mutual fund for a long enough time to burn off that sales charge. What if the fund returned 3% the first year and you need to liquidate the shares? You’ve taken a loss. It’s also important to remember that you don’t need to achieve a 5% return to get back to even, as any potential gains are figured on your account value of $4,750 NOT $5,000. This leaves you needing to achieve gains of more than 5% to just get back to even. What happens when the market is not favorable for this happening? These are all things you need to consider when purchasing Class A shares.
Class B shares charge on the backend, which is typically referred to as contingent deferred sales charges (a fee is charged when you sell shares a specified period after original purchase). These can be appealing to investors with little investment dollars and a long time horizon. This fee structure causes higher than normal expense ratios. Class B shares are slowly disappearing from the mutual fund world.
Class C shares are known as a level load sales charge that charge an annual fee. If an investor has a shorter time horizon, these might be appealing. Class C shares tend to have higher expense ratios than Class A shares. This ultimately causes a drag on your investment over the long haul.
There are pros and cons to all mutual fund share classes and the system itself exists simply as a way to provide compensation for the intermediaries (your broker).
All too often, investors are passive and too accepting of poor fund management. When investors should question things, they rarely do, even when things go horribly wrong (2000 and 2008 are prime examples). There are risks involved with any type of investment and as I’ve pointed out, mutual funds are not exempt from this notion. Their perceived simplicity has made mutual funds very popular, but as with everything else in the investing world, do your homework before jumping in. A financial planner can help you get on the path towards greater confidence in your financial future. It’s crucial to always have a clear strategy and prepare for all possibilities in retirement such as longevity and other life-altering events.
Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.
Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.