While the creation of the mutual fund has been incredibly beneficial for the average investor, it is important to evaluate all sides of what mutual fund have to offer. Mutual funds do provide instant diversification and bring professional management to the individual investor, but are there any downsides? In particular, when evaluating a mutual fund you should be wary of these three warning signs of a bad mutual fund.
If you invested in common stocks yourself, you could purchase shares of any company today and hold them for 50 years without ever having to pay any fees or commission after your initial transaction. However, a mutual fund charges you a management fee every single year even if you don’t change your personal holdings. This is not to say that all fees are evil; annual management fees, expressed as an expense ratio in most mutual fund literature, are common and expected as investors understand that it costs the mutual fund company a lot of money to operate a mutual fund. However, some funds, especially the smaller funds, can charge outrageous annual fees that harm your long-term performance. The Vanguard Group is a standout for its commitment to keeping fees low, with an average annual fee below 0.25%; however, some firms charge 2.5% each year, drastically reducing your returns, especially over a long time period.
While there are many fantastic mutual fund managers in the industry, the hard truth is that many managers will not beat the market, or come anywhere close after fees are taken out. It is also the law of large numbers: at the end of 2010, there were more than 7,500 mutual funds in existence, with more than 4,500 of them categorized as equity funds. Unfortunately, hundreds of those funds will fail due to poor management, and someone will get hurt. This has been seen even recently; thousands of mutual funds were launched during the 1990s, at a rate of 400-800 per year. The number of funds peaked around 2001, and has steadily decreased as poor managers were weeded out by the last two market crashes. While it is hard to tell how a manager will do in the future, it is often a good idea to stick with managers who have a long-term track record and have proven themselves through business cycles.
While style shift is not very common with established funds, some funds with a broad investment mandate may have the authority to switch styles to suit the manager’s desires. While this can help if the fund manager is skilled in many areas and sees unique opportunities, it can also cause your portfolio to become less diversified. For example, if you already have a strong portfolio of domestic blue-chip stocks, you want your foreign small-cap fund to continue investing in foreign small-cap firms, not more domestic blue-chips. If you are investing in a particular style or strategy, be sure to review the prospectus to gauge the level of discretion the manager has, and periodically review the fund’s holding to ensure that the fund it staying true to its roots.
Looking for these three mutual fund warning signs should help steer you away from choosing a poor fund that could harm you in the long-run. You are investing hard-earned money, so it will almost always be the right choice to avoid excess fees, poor or inexperienced management, and funds with shifting styles.