The Great Deception of Mutual Funds

NEW YORK (MainStreet) — The mutual fund world has deceived retail investors for too long.

There is an sense in the general public that the safest and best way for retail investors to buy stocks is through a mutual fund.

Don't worry about short term fluctuations, they think. Don't worry about the daily headlines. You have a mutual fund manager that is constructing a properly diversified portfolio for you. There is no sense in trying to time the markets, so simply keep your money invested in the fund, and you'll do well over the long run.

For example, money managers will appear on TV and tout the robust market, that it is up 62% over the past ten years. The mindset perpetuates this buy and hold strategy.

This number is extraordinarily misleading. Let's dissect these numbers and figure out the real numbers.

Say you invested $10,000 in mutual funds exactly ten years ago. Not only that, but let's assume you equaled the performance of the market -- something quite rare for mutual funds. In fact, the inherent structure of mutual funds prevents them from ever outperforming the market, but I'll get to that later.

You might presume, with the market up 62%, that your original investment is now worth $16,200.

That could not be further from the truth.

First and foremost, we must take inflation into account. With an average yearly inflation rate of about 2.42% over the past ten years, this 62% all of a sudden drops to 27.6%. Don't worry, we are just getting started.

Next, we must take into account that mutual funds do not operate for free, and they can charge some pretty hefty fees. Most people simply look at the expense ratio which is easily found online, and they assume that anywhere from 0.5% to 1% is being taken out of their account each year. Many investors will shrug that off.

But very few investors understand there are "hidden" fees in a mutual fund.

Have you ever looked up the transaction costs of your mutual fund? If not, it's likely because you need to access the fund's Statement of Additional Information -- which is generally not distributed to all investors but available upon request. Transaction costs can include brokerage commissions and fees among other things. Not only do you have to request this document, but the transaction costs are usually not outlined either -- it takes a little bit of math to uncover the real figures. A study conducted by Edelen, Evans, and Kadlec determined that transaction costs generally amount to 1.44% per year.

So far, after subtracting 2.42% for inflation, 0.5% for expenses (this is on the low-end) and 1.44% for transaction costs, we get a whopping yearly return of 0.53% in real dollar terms -- and this is without potential taxes.

All of a sudden that 62% number turns out to be a measly 5.4%.

Not only is this a bad strategy, it is a dangerous one -- especially considering many products and services, like education, are rising faster than inflation.

Moreover, this scenario presumed your mutual funds performed as well as the market. This is incredibly rare, as when mutual funds have a good year, they are generally met with an influx of new capital for the following year. The law of large numbers eventually kicks in, and it's nearly impossible to beat the market.

So, what can you do about it?

You need to manage your own money. Buy a few books, stay current with the news and read company filings that are available for free on the Internet. If you do your homework, both in good times and bad, then you absolutely can outperform the market. If you are afraid, take a small amount to test your skills before you gain the confidence to manage the rest.

This is not about becoming the next Warren Buffet. This is about preventing the mutual funds from taking advantage of the little guy. This is about saving enough for retirement, college, or any of the necessities of life.

Almost every investor has the capability to outperform the mutual funds that rip off so many unknowing individuals.

--Written by Alex Pottmeyer for MainStreet

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