Are Mutual Funds Becoming Obsolete?

The markets that we’ve seen during the past several months are unlike any others I’ve seen in my lifetime.  In fact, they’re probably unlike the markets most of us have ever seen.   This market upheaval has caused me to re-examine everything that I thought was “sacred” about investing and the markets. This in turn has led me to begin questioning many basic premises about how financial planners think about investing, proper diversification, and trading.  Specifically in this article, I’m looking at the future of saving and investing in mutual funds.

I’m by no means an expert in this area.  But I have taken to reading and researching as much as I can about what works and what doesn’t work while saving and investing for the long and short term.  Between listening to tons of podcasts, attending numerous webinars and conferences, reading books, newsletters, magazines and newspapers, I’ve become intimately familiar with the arguments advanced by “buy and hold” crowd and their counterparts, the “market timers.”  I’ve learned that both approaches have their merits, and each has its time and place in the right types of markets.  This article is not about those merits or which method is superior.

While re-examining and researching mutual funds in client and prospect portfolios, and seeing how much some of them suffered in this awful bear market, I keep asking myself if there is a better way to invest their money.  Even though most mutual funds were down 35-50% over the past twelve months, I shook my head in disbelief that many of the same funds, even as late as January 2009, were still ranked as four and five star funds by the investment rating firm Morningstar.  Really?  Four and five stars were given to funds ranked in the bottom 35% of their category?  Funds that had double-digit negative annualized returns for 1, 3, and 5 years still earned three or four stars?

Just to be clear, as an advisor, I don’t rely on Morningstar “Star” rankings to rate and choose funds for my clients and prospects.  I dig much deeper into the details and third party information for comparison, research and evaluation purposes.  But I know that many consumers do rely on star rankings.  And I have to wonder how much of a favor Morningstar is doing for consumers when managers who are paid handsomely to manage mutual funds missed the whole financial crisis and didn’t steer their funds away from the financial or the big oil stocks in the second half of 2008.

In a secular bear market like the one we’ve been in, buying and holding mutual funds (or any investment for that matter) can be a money losing proposition.  But mutual funds have a few characteristics that make them even riskier, if not downright inappropriate for certain market conditions.

One characteristic that makes mutual funds riskier is the once-a-day, end-of-day pricing; you can’t get intra-day pricing on a mutual fund like you can on a stock.  If the market is trending down, there’s no way to cut your losses when the writing’s on the wall and the market’s headed for a big daily loss.  Wouldn’t it have been nice, on an 8% down day, to cut your losses in half?  Well, sorry, you can’t; you have to ride it all the way down.  Of course, on an up day, you may benefit from the extra upside.  Exchange traded funds (ETFs), which trade just like stocks, don’t suffer from this disadvantage and can be bought and sold at intra-day prices.

Another risky characteristic of mutual funds in bear markets, closely related to the above characteristic, is the inability to put a stop-loss order on a mutual fund.  If the market is crashing, and you’re unable to monitor your investments every minute that the markets are open, you could lose big or give up a good chunk of your gains.  Stocks and ETFs don’t have this disadvantage; you can have a standing stop-loss order on them with your broker for up to 6 months.  As soon as the stock or ETF drops to the sell-stop price, a sell is triggered and voila, you’re in cash, protected from further downside.  This gives you time to assess market conditions and decide on your next investment.

The inability of most mutual funds to deviate from their stated investment objectives prevented many mutual funds from cashing out on money losing stocks (almost all of them in 2008) and being able to sit on the sidelines with significant amounts of cash.  Funds with more flexibility in their cash positions, and those with the ability to take inverse (e.g., short) positions fared better than most in this bear market.  To be fair, many ETFs are index-based and have the same problem.

Mutual funds also suffer from a lack of timely disclosure of their investment holdings.  While they all publish their stock and bond holdings, most holding lists are usually at least three months old.  Mutual fund managers don’t like to publish their holdings more frequently so they don’t have to tip their hand to the competition.  It’s important to know what investments your funds are holding so you don’t duplicate or overlap your holdings with funds carrying the same stocks or bonds.  And if your fund was still holding, say Washington Mutual when it was sold for pennies on the dollar to JP Morgan Chase, maybe you would have known better to avoid the fund.  ETFs are much more transparent and publish their holdings on a daily basis.

Many will argue that ETFs have commissions that must be paid to buy and sell them, thereby making them a more costly option than mutual funds. To that I say three things: 1) commissions at most big brokers are about $19.95 or less; 2) the potential higher-gain or lower-loss on an ETF may pay for the commission in multiples; and 3) many desirable mutual funds have transaction fees much higher than ETF commissions at many brokers.

So will the mutual fund industry eventually die? I don’t think so.  Mutual funds are so ingrained in institutional settings and retirement plans that they likely have a long future ahead of them.  But I have a feeling that the mutual fund industry is already trying to reinvent itself.  Many of the big mutual fund companies have gotten into the ETF business because of the net (negative) out-flows from mutual funds and the net (positive) in-flows to ETFs.  Perhaps mutual funds will get some of the nice advantages that ETFs have like intra-day pricing, sell-stops and timelier holdings disclosures.

What I also hope for is that more 401(k) and self-directed retirement plans embrace ETFs and give employees the option to invest in them.  That way, they’re not sitting ducks when the markets come crashing down.

Do you think that mutual funds are headed for extinction? Do you think that employees should have more choices (e.g., ETFs) when it comes to their 401(k) investment choices? Please let me know what you think.

One Response to “Are Mutual Funds Becoming Obsolete?”

  1. Daddy Paul Says:

    “I don’t rely on Morningstar “Star” rankings to rate and choose funds for my clients and prospects”
    I must agree. They do little more than look at fund performance. I have seen a five star fund go to a one star fund and not change managers. If they had done any work they would have seen this coming.

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