4 Reasons Not to Get Into Mutual Funds

In my About Me section I talked about my disenchantment with mutual funds. Sure, in the bull market days when funds were trash if they didn't return over 15% a year, I was pretty happy with them, and I think everyone was. But now it's a bear market and recession and all those other scary words. The market's down, so mutual funds are dragged down with them. We even had a couple of scary moments where your portfolio might have dropped 30% or more and you're lucky if you recovered a year later, much less made any money.

When it's the only game in town, there's no point complaining.
But what if it isn't the only game in town. What if you could buy something else?
I talked about League and the Real Estate Investment Trust, which is tied to shopping mall rentals to mega-chain stores like Superstore. That's not tied to the market, but has various other types of risks -- but risks that are not so much at the mercy of the strange whims of the stock market. Because you can get a reliable 8% there (used to be 9% until September 2011) in a manner similar to locking your money into a GIC for 7 years, there's no point being in any investment that doesn't return more than 8% a year no matter what the market conditions.

So here are 4 reasons not to get into mutual funds:

1. Your "Financial Advisor" is probably just a salesman.

Chances are, they don't know any better than you. They get instructions from head office about what to get based on your risk profile and put it together. Then they do the customer service routine to basically lock you in for several years. They don't really have to do anything to your account as long as you keep your money there. They sit back and collect money for having you as a client -- whether you make money or not. Their real job is to retain you as a client.

Even if they do watch and adjust your account, they will probably have to do it with redemption penalties in mind, which further limits their ability to move and react with the market. So if they do a lot of this at all, it will probably be with their best (highest net worth) clients, out of dozens, of not hundreds, of clients.

If you think about it, this setup lets them collect a heck of a lot of passive income. Some companies have their own stable of funds and most of the time the advisors there will recommend their company funds. If the funds do well, no one complains. But really, isn't that a huge conflict of interest right there?


Keep in touch quarterly (shortly after you get a statement) with whoever you're with: The squeaky wheel gets the oil. None of the advisors I've had have ever called me up to adjust my portfolio. (They have, however, called me up to remind me of RRSP contributions).


2. Most funds track the market anyway.

Every year, people talk about this but no one can do anything about it. Mutual funds must invest in a big basket of stocks to reduce your risk -- basically to not roll the dice on just one or a few stocks. There are winners and losers and it starts to look like the major indexes. This is why people buy funds that mindlessly follow an index. But even that is not a solution to getting better performance.
You could roll the dice on one very volatile fund and hope it shoots up, then exit -- Some funds have done almost 20% for the year ending November 2011. Did yours do that for you?

Your financial advisor is supposed to pick good funds that will give better returns. But they always hedge by saying past performance does not guarantee future performance, so who's to really know if they are picking good ones? Even fund ratings companies can't predict performance and if you look at reports from those, most funds swing up and down the rankings every year anyway. And when markets go down and your fund tanks, your financial advisor can just say the market went down so everybody's down; or you're in position to buy low and ride the market rally up.

Basically, they're probably not much better than picking stocks for you. If you have a higher risk profile, they will pick a higher volatility fund and hope it goes up. If it tanks, they tell you your risk profile was high, so it's your fault.

3. You can only make money when the market goes up.

There are no fancy things like shorting stocks or using options in mutual funds. You make money when the underlying stocks go up. Hopefully, most of them go up, and it's more up than down in the entire basket.
In the broader stock market, you can make money no matter how the market's moving with the right strategy. Not without risk of course, but at least you can make money no matter if the market goes up, goes down, or stays flat.

4. You cannot protect yourself from loss.

For most funds, you can't protect your principal. If a fund starts to tank and never recovers, there's nothing you can do. Some science and technology mutual funds that took huge hits in the big crash of 2000 never recovered -- so much for the "invest for the long term and it eventually goes up" line that you are sold by financial advisors.
In the open stock market, if you know what you are doing, you can hedge your risk and buy insurance for stocks. For example, if your risk tolerance is to not see your portfolio drop by 10%, you can spend maybe 5% to buy insurance (such as buying Puts) when some of your stocks have gone up in value. If they suddenly drop in value below your tolerance, you can exercise your Put and sell them at a higher price than the current market price. You cannot buy options on mutual funds.

This said, some funds do allow you to protect your principal but there are hidden costs such as higher fees and more conservative investments resulting in lower returns.