Mutual Funds, What You Might Not Know

Mutual funds continue to control a dominant portion of individual investor assets, especially in 401K and other types of retirement plans. Mutual funds are great because they offer instant diversification especially for the small investor. Mutual funds are investment vehicles that hold a "basket" of, most commonly, stocks, bonds or a combination of the two with just about every theme and strategy imaginable. There are thousands of mutual funds to choose from, in fact there are more mutual fund choices than there are listed individual stocks.

Sounds good doesn't it? What could be wrong with mutual funds? Plenty, but I will just discuss the biggest problem with mutual funds, cost.

- The cost of mutual funds average between 1 and 1.5% based on what they publish as their expense ratio. But that is only what is required to be made available to investors.
- There is another document, Statement of Additional Information (SAI), which most people don't know about. This document outlines additional expenses in mutual funds for trading and operational costs which average another 1 to 1.5%.
- Not only that if you buy your mutual funds through a commission based broker you could pay an additional 5% fee. - Not only this but if you hold your mutual funds in a non-tax deferred account you could pay capital gains tax annually even if don't sell! The reason for this is because the manager of the mutual funds buys and sells stocks throughout the year and passes on those capital gains to you. Sometimes these capital gains taxes can be more than 10%.
- All these expenses can add up and significantly affect your return and is the biggest problem with mutual funds.

To be fair, not all mutual funds have the problems described above, but most of these issues are more common than not. So, when you consider investing in mutual funds you need to take a closer look at the fine print. Unfortunately, the fine print is not easy to decipher.

Okay, so I told you what is wrong with mutual funds, that's great but where else do you find a diversified investment choice? A great alternative to mutual funds are Exchange Traded Funds, or ETFs. ETFs are very similar to mutual funds in that they typically hold a diversified basket of stocks and/or bonds.

The major difference is that mutual funds trade assets within the fund more actively partially because they need to make trades when investors buy or redeem shares. ETFs hold a basket of assets based on a theme, most commonly an index, and the investor buys or sells those shares on an exchange rather than through a mutual fund company. For this reason ETFs are on average much cheaper than the average cost incurred by mutual funds.

ETFs average less than 0.4% and for most ETFs they generate little or no capital gains unless the investor sells shares. There are some niche strategy ETFs that have come out recently that do generate huge capital gains but I don't recommend these investments unless you understand them fully. But the majority of ETFs have had minimal capital gains compared to stock mutual funds.

ETFs have been stealing market share from mutual funds over the last few years and look to continue in that direction in the future. Unfortunately, ETFs have not been a significant option in 401ks and other retirement plans which many investors participate in so mutual funds may be some investors only option. I believe that ETFs will begin to invade the retirement plan arena as investors demand a reduction in excessive fees associated with mutual funds.