Mutual Fund Illusion – Beware of What Lies Behind the Curtain

Elaine Phipps - MBA, CFA, Portfolio Manager.

Mutual funds offer investors a diversified portfolio of stocks and bonds.  The advantage is you can diversify quickly and with a nominal investment; there’s no need to purchase the underlying securities.  

Many tout the benefits of index fund investing, including low costs, diversification and the inability of professional money managers to consistently beat the market.  However, investors should be aware that they are not buying a panacea.  Here are some of the shortcomings of mutual funds that a buyer should consider.  

Diversification not always guaranteed – Often investors will hold several types of mutual funds.  On average each mutual fund will hold several hundred positions.  As such, the same security may be held in a number of different funds, increasing your exposure to both individual names and sectors of the economy. Mutual fund overlap often leads to reduced diversification.  In addition, one fund may be buying the same stock another is selling, canceling out the desired effect. As a result, the investor shoulders transaction costs and tax consequences without changing the overall portfolio.  

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Fees upon fees – Mutual funds can come with elaborate fee structures which require an investor to carefully read through the fine print.  While pure index funds tend to have low fees, managed funds can have fees in the range of 1-2% or more.  Some mutual funds also charge sales commissions, including loads on the front or back end of the purchase and inflated commissions for soft dollars. Service fees such as 12b-1 fees and operating costs all contribute to a fund’s expense ratio, as does the turnover ratio.  Investors would be remiss to not do the math and add everything up.  These costs are payable regardless of the fund’s performance.  

Lack of control – Mutual fund managers don’t know your personal investment objectives, lifestyle, or risk tolerance.  Are you trying to save for retirement, generate cash flow, buy a house, and pay for college?  As time moves on and you age, your financial needs may change, but the mutual funds do not adjust their strategies.  It is left to the investor to make these important allocation decisions, a task that may be challenging.  Should you hire an advisor just to help you choose the correct mutual funds, your cost structure will increase further.

No tax nirvana – Who is looking to minimize your tax bill?  Certainly not the fund companies, including index funds, who buy and sell in a manner that does not consider taxes. Mutual funds often come with year-end tax surprises in the form of capital gains and taxable transactions which the investor has no control over.  Capital gains are distributed to all shareholders, regardless of whether the investor sells shares or not.  You may buy a fund in December and despite one month’s ownership, still be liable for the full year capital gains tab.  You will even pay capital gains tax if the fund has lost value over the course of your investment horizon. With direct holdings of stocks and bonds, you establish your own cost basis and manage your own capital gain/loss position.   

Read the labels carefully and buyer beware – How does an investor sort through the advertised labels and evaluate what they are buying?   Funds can be described as growth, value, target dated, income, small-cap, and large-cap, to name just a few options.   The SEC requires funds to have at least 80% of assets in the particular type of investments specified in the fund’s name, however the remaining assets are under the discretion of the fund manager.  

Mutual funds do serve a purpose in portfolios, especially for those seeking large scale diversification through a smaller scale investment.  However, should your portfolio size allow for sufficient diversification, consider the benefits of owning direct holdings of stocks and bonds.  Advantages include minimizing costs, controlling your tax outcome and better meeting your investment objectives.

Note: Elaine Phipps, MBA, CFA, is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit.

For nearly 25 years, Point View Wealth Management, Inc. has been working with families in Summit and beyond, providing customized portfolio management services and comprehensive financial planning, to develop and achieve their financial goals.  Click here to contact David DietzeJohn PetridesClaire TothDonna St.Amant, and Elaine Phipps, or call 908-598-1717 to learn more about Point View Wealth Management, Inc. and how we can help you and your family meet your financial objectives. To sign up for our complementary commentaries and newsletters, e-mail us at

CNBC has named Point View one of the Top 100 fee-only wealth managers in America.

The opinions expressed herein are the writer's alone, and do not reflect the opinions of or anyone who works for is not responsible for the accuracy of any of the information supplied by the writer.

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