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.