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Mutual Funds are Toxic for Building Long Term Wealth

Mutual funds will cease to exist in their current form.  Low rates and compressed returns will expose archaic investment vehicles that are tax inefficient, cost too much, and fail to perform most of the time.  Much has been made about the movement to passive investment vehicles, but ~78% of global investable assets are still under the active mutual fund umbrella. 

Retail investors have been pushed into mutual funds by financial advisors through their 401k plans, IRA’s, and taxable investment accounts.  Advisors like recommending mutual funds because they are essentially outsourcing the investment management.  This frees them up to go out and chase down the next deal.  In addition, many advisors have “preferred” funds on their menu, and receive additional compensation for using ‘A’ or ‘C’ share classes.  This is a major conflict of interest that is rarely disclosed to the investor. 

The cost of owning mutual funds is the least transparent expense investors pay.  The mutual fund expense ratios do not show up on the client statement.  Rather, they are automatically taken out of the net asset value (NAV) of the fund on a daily basis.  The daily administration of the mutual fund fee is designed to smooth or cloak the impact of the expense.  Investors never see it and advisors never talk about it.  Gross returns are fine for comparative purposes, but net of fee and after tax returns are the only real performance measurement that matter for investors (which advisors never talk about either).

The tone of this blog would imply I’m a proponent of passive only investment strategies.  That’s only partly true.  I believe active investment management has a place, but I don’t want to pay a premium for the ‘promise’ of outperformance (especially when the majority of active managers consistently underperform their respective benchmark).  The truth is low cost active management does exist, but it’s outside of the mutual fund umbrella.  Active beta exchange traded funds, separately managed accounts (SMAs), and unified managed accounts (UMAs) allow an investor to express their views on the market in a more cost and tax efficient manner.

Disclosure: Pure Portfolios does not use mutual funds to construct client portfolios.

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