Investing: Why Mutual Funds Suck

It seems that many investors are trailing the rally on the stock market, at last those who are invested into stock mutual funds. A new statistics published in the New York Times shows, that "in the two decades through December, the average return of all investors in U.S. stock mutual funds was an annualized 4.25% versus 8.2% for the S&P 500" (nytimes). "That translates into a difference of $25,467 for an investment of $10,000", comments the service Seeking Alpha (seekingalpha).

This is not a surprise. The average of the (managed) mutual funds performs generally worse than the stock market index. There are 2 reasons for that:

1. Funds are very costly: The fund administrators spend a lot of money for salaries of the fund managers, research, administration, lawyers, marketing and more. Furthermore, fund managers are continuously buying an selling stocks which causes extra costs (transaction costs). All these costs are paid from the money of the clients meaning that the expenses are deducted from the value of the fund portfolio and therefore reduce the performance of the fund. If for instance the portfolio climbs 10% and the costs are 3% then the net value of the fund rises just 7%.

2. Fund managers often make mistakes when they are buying and selling stocks. The majority shows a typical herding behavior: When the stock market falls, many fund managers get pessimistic and they sell in groups which results in even lower selling prices. When stock prices recover, the flock buys the shares back, driving the purchasing prices even higher. Hence, fund managers often sell cheap and buy dear.

One of the biggest mistakes is that fund managers hold too much cash. Usually funds don´t invest all the money they get from their clients because they want to be liquid in case their clients wish to withdraw a lot of their money (sell fund shares). They also hold cash in the hope to get a better opportunity to invest. The cash holdings are usually held in highly liquid bank accounts or in money market funds. This money doesn`t participate when the stock market rises and dilutes the performance of the fund portfolio further.

Better Alternative

Investors who want to participate fully in the advance of the stock market could do that by buying ETFs (Exchange Traded Funds) on indices. There are at least 2 ETFs that track the S&P 500: The "iShares S&P 500 Index Fund" (symbol: IVV finance.yahoo) and the "SPDR S&P 500 (symbol: SPY finance.yahoo).

These funds invest the whole money in stocks which are part of the S&P 500 and they have the same structure. Investors can buy & sell these ETFS on the stock market like stocks with the same transaction costs.

Both funds move almost exactly in cadence with the S&P 500 hence investors won´t miss the further advance of the stock market. You also could follow easily  IVV and SPDR on finance sides like Yahoo Finance, Google Finance (google.com/finance) and others.