I no longer believe in mutual funds. Earlier I thought they were a great investment vehicle, because they can provide diversification. But is it really such a significant trait of the funds that it can beat mutual funds flaws?

People, those slightly informed about investing, know that generally, 95% of mutual funds do not exceed or keep up with the overall market. Ninety five per cent of fund managers lose money compared to the benchmark. Those managers are the true suckers when speaking of investing.

There are less known facts about the mutual funds, which investment salesmen, advisers, mutual fund managers (Wall Street) and Washington will never tell you. Lets take a look at a few of them.

What is your mutual fund doing with your money?

Do you know how good or bad your mutual fund is in investing your money? How do you find out? How do you want to evaluate and research the funds fundamentals to find out whether it is making you money or losing you money, whether it is a money making machine or a loser? The only way you can rely on is the past performance, but how reliable it is?

How many times you have read in the news something like “the mutual fund managers rushing into stocks to chase the performance”?
Can you tell whether your fund manager is day-trading or following a long term investing strategy to save you money?

Turn over or churn is your enemy

When I started investing I hated a strategy to buy a stock and forget about it. I wanted to get rich quick by hitting a home run. I wanted to buy a stock which would multiply tenfold and made me rich. So I was trading. I refused to acknowledge that I was acting like a sucker. And I was losing money.

Truly I did hit a few home runs. But I was so obsessed with trading that I wasn’t even able to let that winner run and I sold it prematurely. Remember Netflix when it was trading at $44 a share? I bought it at that price before it skyrocket to 300-ish levels, but sold it way before it run in there.

Six years later I must humbly admit, that this was a sucker’s game. Unfortunately there are fund managers out there who play this game today. You can refer to those funds as actively managed funds.

Of course, you can find funds known as index funds or fund tracking one of the market indexes. So you would think these have a very little churn right? No they do not. When researching it, then you find out that their turn-over is at 90% or around that number. How is that happening? Any time you or investing public puts money into the fund or redeem money from the fund the fund manager must buy or sell shares to get money for you. This contributes to the overall churn of the fund. It won’t go away, you cannot escape it. And what are the consequences? Read further.

There are two things in the world you cannot escape – death and taxes

Have you seen a movie “Meet Joe Black”? Joe Black (Brad Pit) is helping Bill Parish (Anthony Hopkins) saving his company against Drew (Jake Weber) plotting to sell Parish Communications. At the board meeting Drew states:

Drew: We all know this deal is as certain as death and taxes.
Joe Black: Death and taxes?
Drew: Yes.
Joe Black: “Death” and taxes?
Drew: Yes.
Joe Black: What an odd pairing.

You cannot escape death and you cannot escape taxes. Unlike in certain accounts where your taxes are deferred, mutual fund heavily generates them.

I said there are two things you cannot escape, but I would add a third one – fees. You may be able to defer taxes if you hold your mutual funds in your ROTH IRA or IRA or 401k accounts, but in most cases you won’t defer fees.

Compared to you as individual investor investing in individual stocks, you can almost eliminate taxes on capital gains and limit fees to a very minimum. If you buy dividend paying stocks and leave them for 30 years in your account, you will only pay a fee when originating your purchase. No more fees and taxes as long as you hold. And since you can hold literally forever because it is the dividend income, not capital gain income which interests you, you only pay taxes on your dividend income. The difference in fees and taxes between this strategy and mutual fund with 150% turnover is tremendous.

Every mutual fund collect seamlessly a variety of fees which eat up gains you may have if any at all. Regular investor usually have no clue what fees the fund charges and how they affect the performance. The funny part is that the fund usually reports its performance without discounting fees and taxes. So if you read that your mutual fund gained 13% last year you may feel like a king of the world. The reality is however far from the bright future. When the fund discounts the annual management fee (expense ratio) , marketing and distribution fee (12-b fee), redemption fees, load fees you may end up with a loss or very low profit, which will be further destroyed by taxes and inflation.

If you compare this performance with investing on your own into individual dividend paying stocks then $1000 invested for 30 years in mutual funds would translate into $13,000 compared to $63,000 when invested into individual stocks.

Is diversification, mutual funds offer, worth it? In my opinion, the answer is a resounding no.

Conclusion

Because of mediocre performance, high taxes and fees charged by mutual funds I decided not to invest into mutual funds anymore. I believe, that good quality dividend paying stocks with long history of dividend payout and great dividend growth you can perform almost fivefold better than any of the mutual fund manager can ever dream of. Unfortunately I have to have mutual funds in my 401k account, since I have no choice in our plan. That’s why I contribute only the absolute minimum to get my employer’s match. The rest goes to my individual accounts where I invest into individual stocks only (and basic option strategies).