April 10, 2011 in Business

Experts debunk mutual fund investing myths

Mark Jewell Associated Press
 

BOSTON — Whether you follow Wall Street or not, odds are you’re a mutual fund investor. Mutual funds are the foundation of 401(k) plans and individual retirement accounts.

Yet many investors lack the patience to learn the finer points of funds, or give up trying. They’re intimidated by jargon such as “expense ratios” and “basis points.” Such fear can lead to poor choices that lock in years of high fees and subpar returns.

Still others think they know their stuff, and mistakenly move in and out of pricey funds that are hot performers, however fleeting. Over the decades, seemingly trivial differences between the returns funds deliver and the expenses they charge can have a huge impact on retirement security.

The stakes are big. More than 87 million individuals own mutual funds, and fund companies manage more than one-fifth of household financial assets, according to industry data.

A good starting point to a successful long-term strategy is recognizing misperceptions that trip up many fund investors. Below are top myths that three experts highlighted in recent interviews:

BURTON MALKIEL, a Princeton University economist, and author of the investing classic, “A Random Walk Down Wall Street.” The former director at fund company Vanguard is an advocate of low-cost index funds, which seek to match market performance rather than beat it.

Myth: It’s easy to find a good actively managed fund. Just pick one that’s been beating the market.

Actively managed funds typically charge more than index funds because of the payroll costs for the investment professionals calling the shots. Research by Malkiel and others shows that the strong returns of active funds are almost always fleeting when measured against the decades needed to save for retirement. Malkiel cites the example of 14 stock funds that beat the Standard & Poor’s 500 index for nine consecutive years, ending in 2007. The next year, when stocks tanked, just one of those 14 beat the market.

“There are Warren Buffetts from time to time, and there will be in the future,” Malkiel says, referring to the legendary investor. “But it’s basically impossible to know who that’s going to be.”

Myth: You get what you pay for in investing — higher fees generate bigger returns.

It’s tempting to choose a fund that’s been posting big returns lately, even if it charges higher-than-average fees. That’s because gains from the manager’s recent picks can make fee differences look puny. But expenses are a definite and easily measured drag on future returns. Over time, costs are almost always a bigger factor in fund returns than investment selection, Malkiel says:

“The idea that you get what you pay for is wrong — it’s quite the opposite,” Malkiel says.

MICHAEL FINKE, associate professor of personal financial planning at Texas Tech University, and a widely published fund investing researcher.

Myth: All mutual fund fees are bad.

Many funds assess sales charges upfront, along with the ongoing expenses that cover operations. Yet there’s another one-time charge that might actually make long-term investors money: redemption fees. About one-quarter of funds charge investors who pull out of a fund shortly after getting in, typically within six months or less. The charges are capped at 2 percent of the amount invested.

These fees became common after a scandal in 2003 when some funds were caught favoring certain big investors who frequently moved in and out of the fund. Such rapid trading can saddle all of a fund’s investors with higher costs, eroding returns. Many companies tried to regain favor with long-term investors by initiating redemption fees.

Research co-authored by Finke showed that many mutual funds that charged redemption fees had significantly higher average returns than comparable funds that didn’t charge — as much as 3 percent in some instances. Advantages were most apparent for funds investing in stocks of small companies. However, many fund companies are now abandoning redemption fees because they present a marketing problem. Investors tend to avoid anything resembling an extra fee, even if few pay them.

“But if you’re a long-term investor,” Finke says, “you want a fund to impose fees on short-term investors that are taking money out of your pocket.”

Myth: You need more than one mutual fund.

Investors are told to mix things up by investing across the stock market, and include bonds as well as alternative assets like gold or real estate. The implication is you need several funds. Finke argues most investors would do fine with just one fund, provided it has a broad focus. He suggests target-date mutual funds that adjust to a more conservative mix of assets as the investor approaches retirement. Be choosy, though. Performance can vary widely for funds with the same target retirement year. Another option is a diversified stock index fund charging low expenses.

“Sometimes putting all your eggs in one basket is the best advice after all,” Finke says.

RUSSELL KINNEL, director of mutual fund research at Morningstar Inc.

Myth: All index funds are low-cost.

Index funds typically charge less than actively managed funds, but there are exceptions. One reason: Index funds tracking the same market segment charge vastly different expenses. Expense ratios for funds tracking the S&P 500 run as low as 0.06 percent to 2.28 percent. Most of the pricier ones are burdened by small size. Fewer assets mean the fixed portion of a fund’s costs is spread among a smaller number of investors, leading to higher expenses. Kinnel notes that some large actively managed funds can beat index funds on expenses. One example: Dodge & Cox Stock (DODGX), which charges 0.52 percent, and invests in many of the same stocks as S&P 500 index funds. Over the past 10 years, its return outpaces the S&P and ranks in the top 13 percent among large-value funds.

Myth: A fund manager who suffers one bad year isn’t worth your investment dollars.

Misguided thinking about short-term performance often leads investors to drop funds that have recently lagged in favor of ones that are streaking. Resist, Kinnel advises.

“Every manager has a bad year,” Kinnel says, “You don’t get significantly dumber or smarter in a year.”

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