Mutually Beneficial?

Mutual funds have returned to the spotlight in recent weeks, with big news at a couple of fund shops highlighting some of the investment vehicle's inefficiencies. Don't get us wrong, mutual funds can provide some valuable benefits, but they have drawbacks as well-particularly for larger investors-and anyone in or considering a mutual fund-based strategy should carefully weigh the minuses as well as the plusses when assessing whether funds are right for them.

We aren't inherently anti-mutual fund, but their benefits aren't universal. In our experience, smaller investors tend to reap the most. For instance, mutual funds provide automatic, broad, cost-effective diversification, which is difficult to achieve in a smaller portfolio with individual stocks. Proper diversification usually requires owning dozens of individual securities, and doing all the necessary research is time-consuming. Owning a fund lets investors outsource this, saving bundles of time. It can also save smaller investors money. Purchasing dozens of securities racks up transaction costs, often assessed at a flat fee for smaller trades. If you try to diversify a $10,000 portfolio with individual stocks, you might buy 60 or so stocks at a minimum commission around $9 per trade-all totaled, a cost greater than 5% of the total portfolio value. That high cost could outweigh the benefits of diversifying. Funds, which benefit from economies of scale, are probably a more effective option. Funds also allow investors to distribute money without having to decide which stocks to sell or risking interfering with the integrity of their strategy. Selling shares of the fund is a lot easier-and likely cheaper-and leaves the strategy intact.

For larger investors, many of these benefits fade as it becomes more cost-effective and efficient to diversify with individual stocks. Mutual funds' tax inefficiencies also come to the fore in larger portfolios. On average, mutual funds turn over almost their entire portfolio each year. In addition to racking up trading costs (which funds pass on to consumers but aren't required to disclose), high turnover can result in high realized gains. By rule, mutual funds must distribute realized capital gains to shareholders, a taxable event. Here's the kicker: Funds make these distributions on a per-share basis, without considering whether a given shareholder was there the entire time the fund owned that security. If you buy at the right (err...wrong) time, you could get stuck with a huge tax bill for gains you technically never received. Yes, you will have received the distribution, but all it does is reduce your principal, as the fund's net asset value is adjusted for the payout (similar to a stock dividend being deducted from the share price). Adding insult to injury, if a bunch of other folks sell out of the fund, the securities sold to fund their redemptions can trigger realized gains for you, too.

Many investors learned this the hard way last month, when one fund announced a capital gains distribution equal to 81.8% of its net asset value. The longtime manager stepped down earlier this year, and the new manager decided to shift the fund's approach from small-cap to value, with no size parameters. As a result, he turned over most of the portfolio, realizing gains on securities the prior manager had held for years. Now, this was fully telegraphed to shareholders, who had plenty of warning about the distribution and were well aware the fund was evolving. But it illustrates the point: If you don't monitor fund turnover and upcoming distributions, you can get shell-shocked when the tax man cometh.

This saga brings up another caveat: Fund managers come and go all the time, which can make it difficult to evaluate a fund's performance history. According to Morningstar, as of 12/31/2013, more funds had manager tenure of zero to three years than any other bracket. You may own a fund that had great returns over the last year or two, but if a new manager steps in, future returns may be vastly different. It's a common axiom that past performance doesn't guarantee future results, but a different person making all the investment decisions gives this truism a whole new meaning. Knowing how returns were generated-and who generated them-is just as important as knowing what the returns were. Short tenures also make it difficult for investors to properly evaluate their funds' managers. Seeing how a manager does over a least a full market cycle shows how well they navigate a variety of market environments, and the average manager doesn't even last as long as the typical bull market, let alone a bull and bear.

High total costs are yet another downside. Funds charge multiple layers of fees, and although regulations require transparency, totaling them-and performing a full cost/benefit analysis-can require a couple hours with a prospectus and a calculator. In addition to management fees, funds pass on many costs to shareholders, including operational expenses, marketing costs and other administrative items. Marketing costs, by law, fall under the category of 12b-1 fees. The fee gets its name from a section of the Investment Company Act of 1940 and is essentially a commission paid to sell the fund. Funds can directly charge shareholders for these expenses only if done so under a 12b-1 plan, and they must disclose the fee in the fund's prospectus. However, not all funds follow the rule. Recently, the SEC sanctioned a fund manager for taking marketing and distribution expenses above and beyond the 12b-1 plan, sticking shareholders with even higher fees. While this is the first major enforcement action, industry-watchers suspect it won't be the last, as regulators have heightened scrutiny.

Fees and taxes aren't the only drawbacks to owning funds. Many investors hold multiple funds with similar styles, to diversify across management approaches and performance. But because many broad-based equity funds share common positions-especially the top holdings that comprise a sizable chunk of the market-investors duplicate these stocks in their portfolios. Instead of diversifying, investors concentrate their accounts in these stocks, increasing risk. Or one manager could buy a stock as another sells it, with no net change in your portfolio. The "expertise" cancels itself out.

Again, we aren't anti-mutual fund. For some investors, particularly those with smaller portfolios, the benefits might outweigh the costs. But for those who have built up a sizable nest egg, there are other, more transparent, more cost-effective and more customizable ways to diversify.