Mutual funds stir up heated debates all across the internet. Fund companies sing their praises while others say they are taking you to the cleaners. It can be confusing – are they good or bad? What’s the real deal with mutual funds?
A game-changer for investors
Mutual funds democratized the stock market, making investing accessible to more people, and this was a very good thing. Before the popularization of mutual funds in the 1950’s, it was more difficult to get your money invested in the stock market: you needed a stock broker to buy stocks for you and you needed a fair amount of money.
The idea behind a mutual fund is simple: collect money from a group of people and hire professional money managers to invest this pool of money into dozens of stocks, generating a return for the investors. It’s the pooling of money that is so powerful - it allows a fund to be diversified, giving investors exposure to a myriad of stocks instead of just a few. As an individual investor, you’d need a lot of money to get that kind of diversification. And whereas a broker would charge a large commission for every trade, a mutual fund has economies of scale, making the costs lower overall. Plus, as a mutual fund investor you don’t need to know one single thing about the stock market. What a win for the masses!
The downside
So why do mutual funds get a bad rap sometimes? It’s mainly because sales practices around mutual funds have a muddied history. Investment advisors who are making recommendations to their clients about what to invest in might be influenced by sales commissions, possibly encouraging them to put their clients’ money into funds that pay them the most commission. Worse, these commissions (and other perks that used to be permitted) were not always properly disclosed to clients. Regulations have improved in this area, but sales commissions can still influence an advisor’s choice of funds.
The other reason mutual funds get a bad rap is that they can be expensive to own. Paying fees to own a professionally-managed mutual fund isn’t the problem – in fact, you should pay fees when a service is provided. The concern is around the trailer fee. A trailer fee is the portion of the mutual fund fees you pay that goes to the financial advisor for giving you advice. Again, paying for this service is fine as long as the advisor is giving you high quality service, good advice, and unbiased investment recommendations - and the fees they receive are clearly disclosed to you.
Another mark against traditional mutual funds is that despite the fact that you are paying professional money managers to make all the investment decisions, the fund might not perform well. In fact, the majority of funds do not perform better than the overall market. This is because picking winning stocks is really hard to do consistently.
So are traditional mutual funds good or bad? They are a great option for people with small amounts of money to invest, and for those who have so little interest in investing that they don’t want to spend any time thinking about it. But for others, there are less expensive and very effective ways to get invested in the market, such as owning exchange-traded funds as a do-it-yourself investor or by using a robo-advisor.
Feel good about your decision to be in the market
Should you feel like a sucker for investing in mutual funds? No. Being invested in traditional mutual funds is better than not being invested at all. Paying mutual fund fees to have your money in the stock market should have made you more money than letting your money sit in a savings account or a GIC. Also, despite a less-than-perfect reputation, the mutual fund industry is full of good people. I worked in the industry for more than 15 years and I can attest to it.
Knowing the real deal with mutual funds means investors can make an educated decision to own them with an understanding of what they are paying for.
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