Mutual Funds & The Battle for the Soul of Capitalism

This question is a common question we get from people who first hear our investing opinions.

And we love tackling it.

You may have heard our story about investing in mutual funds back when they were all the rage in the mid and late 1990’s.

I recall when a friend invested in an “Emerging Markets Mutual Fund” and made something like a 90% return over a couple of years.  It was incredible.

So when I had the opportunity to invest in mutual funds through my financial planner I was super excited.  I had read a lot of books on investing and was committed to putting 10% of my earnings into mutual funds.

After a couple of years, I began to notice a disturbing theme.  The management fees *seemed* to eat up a lot of my profits.

So if I made a 7% return I was losing what felt like half of that to management fees and inflation.  In the end, I was actually getting about  1 or 2% return on my money.

And every time I confronted my financial planner with this there was always an excellent answer on how management fees were being restructured and that I really wasn’t losing as much as I thought to fees.  He went on to explain that I was really only losing about 10% of my returns to fees because the expense ratio was 1.3% or so and that through the magic of compound interest I would be OK.

I found it difficult to prove that I was actually losing as much of my profits as I thought I was.

Deep down, something bothered me.

I was putting up all the money and taking all the risk.  And I was only getting some of the profit.  But because it was next to impossible to prove this it was difficult to win an argument with my financial planner.

So I quit mutual funds.  Dumped them all and went into stocks and options.  I started taking direct control of my investments and began trading puts and calls on various stocks and became a student of Technical Analysis.

Shortly after that, I learned that I wanted even more control of my investments and Nick and I began investing in real estate.  That became our asset class of choice.

And in reality, it’s been a good move.  Every single mentor we’ve had has generated income either through a very high salary or through running their own businesses.  They then take their cash and invest in real estate and some commodities, like Gold and Silver.

Everything fell into place for us as we began doing exactly the same.

It wasn’t until several years later that I stumbled into the teachings of John C. Bogle.

In 1974 John C Bogle founded the Vanguard Group and grew it to become the second largest mutual fund company in the world.

He has since gone on to become an outspoken critique of the entire industry.

And from his writings and research, I finally had found the data that proved mutual funds were not serving me well back in the 1990’s.

I’m going to quote from his book, The Battle for the Soul of Capitalism:

Before costs are deducted, the average mutual fund should earn the market’s return.

That makes sense, right?  A good mutual fund should match the return of the broader market.  Or ideally, beat it.

Now John begins to rip that theory apart:

When these returns are compounded over the years, the gap between the return earned by the stock market and the return earned by the average mutual fund reaches staggering proportions, as shown in Table 7.2.

The table shows that even over as short a period as twenty years—the expected investment lifetime of a new investor today is at least sixty years– fund costs consumed more than 40 percent of the return provided by the stock market itself.  Put another way, an initial investment of $10,000, simply invested in the stock market in 1985, would have produced a profit of $109,800.  The profit on the same investment in the average mutual fund would have come to $62,900.

Looked at yet from another perspective, the investor put up 100 percent of the capital and assumed 100 percent of the risk, but collected only 57 percent of the profit.  The mutual fund management and distribution system put up zero percent of the capital and assumed zero percent of the risk, but collected 43 percent of the return...Almost half of the fund owner’s money was siphoned away by those who quite literally had everything to gain and nothing to lose.

Ah, what a guy, eh?

How’s that for summing things up?

Here’s one more quote from his book:

Fund investors and the public have been educated to measure fund management fees and operating expenses as an annualized percentage of fund assets.  So the resulting expense ratios … inevitably take on a de minimus cast.  Tiny numbers like 0.92 percent, or even 1.56 percent, seem almost trivial.  Yet when we examine expenses as a percentage of a fund’s dividend income, the numbers take on a more ominous cast.  Indeed, as noted in chapter six, with today’s dividend yield on stocks at about 1.8 percent, a typical 1.5 percent equity fund expense ratio consumes fully 80 percent of a fund’s income.

It could be said that expense ratio data conceal more than they reveal.  First, because expense ratios represent only about one-half of the true cost of owning mutual funds; hidden portfolio transaction costs and sales loads likely double the typical cost of equity fund ownership, raising from 1.5 percent to as much as 3 percent of assets.

Equity fund investors paid costs estimated at $72 billion in 2004 alone, and as much as $300 billion over the past 5 years.  That is what investors paid for and it is therefore what they didn’t get in terms of net returns that were available in the stock market.

What’s The Bottom Line?

Mutual funds only return 57% of what the stock market does.  They eat up 43% of your profit with their expenses.

So what do you do if you really want to invest into to stock market?  The only way, for us, is to use Exchange Traded Funds (ETFs).

In our opinion, real money will very rarely be made investing in an ETF and it definitely will never replace actively investing in real estate or actively building your own business.  But, they sure seem like a much surer bet than the typical mutual fund.




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