Are Mutual Funds Good or Evil?

Are mutual funds good investments given all the alternatives you have like index funds and ETF’s? This is a good and sensible question.

We are in the “Golden Age of Frugality” after all . There are no two ways about it. And mutual funds cost more to own than ETFs, index funds or stocks. That being the case, why should anyone buy a mutual fund when they can buy an ETF that charges just a fraction of the mutual fund fees and expenses? The answer isn’t as clear cut as it may seem. Let’s take a look by comparing the mutual funds and ETFs.

As you probably already know, mutual funds have active managers who buy and sell securities based on their own preferences and modalities. An ETF on the other hand doesn’t trade stocks. It buys and holds stocks that make up an index. Since stock indices typically change once a year (at most) the stocks that are held in the ETF are usually held for a year. That means there isn’t much trading going on. And less trading saves you money.

Also since the make-up of the index is publicly known, the people who run the ETFs don’t need to have fancy pants (expensive) fund managers. They don’t need to trade and they don’t need to do research. Taken together, this means ETF investors save a ton of money in lower expenses compared to a mutual fund.

Does this mean only an imbecile would buy a mutual fund? Not by a long-shot. Believe it or not, there are distinct advantages to owning mutual funds that ETF’s can’t match.

1. Talent

Mutual funds are more expensive. This is true. But they use that money to hire top fund managers and research departments who are (hopefully) worth the cost. If you were to try to hire one of these managers yourself you’d find it difficult because they typically only work with people with extremely high account values. With mutual funds, you have access to these wunderkinds with as little as $100 to invest.

2. Performance

While most funds fail to outperform the market, some funds do deliver outsized returns. If you develop a system to identify those funds (and are willing to accept the fact that you won’t get it right every time) there is no reason to settle for ETFs with only average numbers.

Remember performance is quoted net of mutual fund fees. So when you evaluate mutual fund performance you can easily compare apples to apples without doing fancy math. What you see is what you get.

There was a fascinating study done by Terrance Odean several years ago that found consistency in mutual fund outperformance. In other words, funds that are doing well now have a tendency to continue doing well. In Odean’s case, he found that the typical period of consistently good performance was 13 months. This is important.

If Odean’s study was correct it indicates that funds can outperform the market but that after a year or so, they tend to stop doing so. If this is true it makes the case for watching performance numbers and rebalancing your accounts accordingly. It also makes the case that buy and hold investing is actually very risky and that it may be very smart to buy a fund rather than an ETF at times.

Economic conditions change over time (which might explain why an out of favor fund may come back into favor). Why not allow those mutual fund managers who are in the right place at the right time to make you money?

When the market shifts and those same funds fall out of favor, why not let the market tell you so? And, as I said, mutual fund performance numbers are presented net of fund expense. That being the case, if you invest based on performance, it just doesn’t matter that funds cost more.

When Not To Use Mutual Funds

If you are a “buy and hold” investor, ETFs are likely a better fit. That is because even if you own a great fund now, it will fall out of favor at some point. That being the case, it would be better to take advantage of the lower cost ETFs.

In my opinion, buy and hold investors are the only people who should only use ETFs and rule out the use of mutual funds. If you are a performance-driven investor, allow both mutual funds and ETFs to be included in your universe of securities and select those with the best relative performance.

Do you use mutual funds? Why or why not? What is your investment approach?