In addition, there are some inherent disadvantages that come with funds that you wouldn’t have to address if you stuck with stocks. Despite these, I’d still choose funds any day, but I think it’s wise to understand the potential drawbacks. They include:
• Tax impact.
• Management costs.
• Fund size.
• Purchase and sale timing.
Tax Impact
Under investment law, funds must distribute any gains they have to the investor each year. That means you could have a short- or long-term capital gain on which you would have to pay tax. That said, many managers have recently become more tax conscious and are trying to offset gains and losses within a fund, thereby reducing the tax burden. As of this writing, there is pending legislation to reduce the tax burden on funds. If it becomes a law, then some of the gains would not be taxed until the investor actually sells the shares in fund.
Management Costs
Excessive management costs could be a disadvantage to owning a fund. The average expense ratio for an equity mutual fund was about 1.4 percent at the end of 2002, according to Morningstar. (The annual expense ratio is described by Morningstar as the percentage of a fund’s assets that is deducted each year to cover such expenses as administrative and operating costs.) I think even this is too high and needs to be reduced, but I still like funds. You can educate yourself about costs and pick your funds accordingly. Two fund families noted for low annual costs are Vanguard and American Funds. When taking costs into consideration, don’t confuse the annual management fee with a load. There’s a difference.
For instance, American Funds have a load, but the annual management fee is much lower than that of most funds. I will discuss load funds in Chapter 6, but suffice it to say that I don’t believe a load fund is in and of itself a disadvantage.
Fund Size
Sometimes a fund becomes so large and has so much money to invest that its flexibility is reduced. This can become a disadvantage to investors in that fund. The greatest concern about size generally relates to funds that invest in small companies, because only so many good small companies exist. A manager of a fund that invests in such companies could run out of options and be forced to start investing in larger companies. Since that is not really the market segment that the manager is experienced in, the fund’s performance could suffer.
Purchase and Sale Timing
Unlike stocks, you cannot buy or sell funds in the middle of the day. When you invest in a fund you get the price at the end of the trading day. Likewise, when you sell you get out at the end of the trading day.
The fact that you don’t know exactly what price you’ll be selling at until the end of the day means you could get a higher price or a lower price than was in effect at the time you placed your buy or sell order. Generally, this is not a significant problem, particularly for long-term investors. Poor performance, taxes, costs and reduced flexibility. These are real issues with funds. But they don’t mean that the entire fund industry is a scam. Rather, I urge you to take these factors into consideration when you choose funds.
There is one downside of funds, though, that can’t be avoided by fund choice. That’s the fun factor. Some folks just find funds dull. They crave the thrill of stocks. And to a certain extent that’s understandable. While individual stocks carry enormous risk, they can also hold out the hope of enormous potential upside. Huge upside—the proverbial killing—is a lot tougher to get with a broadly diversified mutual fund where assets are spread out. Remember that fund that held 100 stocks? If five do incredibly well, their gains can only have so much of an impact on the total returns. The 95 other positions that are good, fair, or lousy balance out the big winners.
But by now you know my theory on this: Fulfill your thrill cravings in Vegas. The goal with successful investing is consistent returns that build over time, not one-hit wonders. If you really need to satisfy your hankering for excitement in the stock market, set aside a small trading kitty—no more than 5 percent of your whole portfolio, preferably 1 to 2 percent. Then trade and trade and trade that to your heart’s content. For the rest, stick with funds.
Read More : The Downside of Funds
