After the last 18 months in the stock market, many investors are shell-shocked. They thought they were on track, setting aside money, investing regularly in preparation for retirement.
Then after the market top in October 2007 the economy contracted, the credit crunch hit, and the market collapsed. As the bull market of the last four years ended, most investors were unprepared for what happened in the last year and a half.
Worse, most of them took no action to protect themselves during the worst market pullback in decades. If you’ve had the courage to look at your retirement account statement lately, it isn’t pretty.
What happened, and what can you do to avoid catastrophe in the future?
Mutual Fund Mentality
It may not be your fault that you were so unprepared for the bear market that clawed its way through your retirement account. If you’re like most individual investors today, you’ve been encouraged to have a “mutual fund mentality” about investing.
Somewhere along the line you were convinced that mutual fund investing is a low-risk, high-return way to financial success. It’s not.
You were persuaded to put your faith in an actively managed mutual fund. Told that a professional manager would adjust your fund’s holdings to maximize profit, even beat the market. Advised that an active, professional manager would limit your downside risk. Warned that he or she could get better returns for you than you could get for yourself in today’s markets.
It’s the mutual fund mentality that is causing some of the biggest mistakes in for investors today.
Mutual funds are far riskier than most investors recognize. Commissions, overhead costs, management fees, lackluster returns and inadequate risk management can add up to an insecure financial future for you.
What’s the Catch?
Why have mutual funds become so popular, and why were you encouraged to invest in them? In a word: incentives. Mutual funds are incredibly lucrative for those who market, sell and manage them.
Excluding retirement plans sponsored by employers, more than 75% of mutual fund investors own shares purchased through a financial advisor. Your financial advisor has a significant incentive to recommend a mutual fund to you. It’s called a commission. Don’t be misled; unless your advisor is exclusively fee-based, ANY fund he recommends to you gives him some financial incentive.
Many traditional mutual funds have an up-front sales charge, or front-end load. They vary widely; the up-front sales charge for mutual funds can be as high as 8˝ %. That’s money a broker, financial planner or other commissioned agent takes immediately. It’s money that comes out of your pocket.
You may be saying to yourself, “I didn’t pay any up-front commissions when I bought shares in my mutual fund.”
Perhaps, but your advisor still got his commission, and you’re paying it. Depending on how the fund is structured, you could be committed to a back-end load which pays the commission your advisor received when he sold you that mutual fund.
A back-end load is the deferred sales charge you commit to pay when you redeem or sell your shares. It’s often much higher than a front-end load. Fortunately, the back-end load does decline over time and usually disappears completely by the end of eight years.
So isn’t that good? Not necessarily.
All back-end load mutual funds charge an ongoing type of fee known as “12b-1 fees” to offset the advertising, marketing and sales expenses they incur promoting their funds. In other words, you pay commissions through ongoing fees instead of a lump sum up front.
So even if your advisor sold you “commission-free” mutual funds, you are still paying fees to defray the expenses of marketing and selling those funds.
Maybe you’re a do-it-yourself kind of investor who has invested in actively managed “no-load” funds. Unlike traditional load funds, no-load funds have no up-front sales charges and no redemption charges.
But they still charge fees. The 12b-1 fees charged by mutual funds of all types never go away. While it’s true a no-load fund will have lower fees, over time those fees really add up, and they reduce the returns in your retirement account.
Here’s the catch: You pay, one way or another. As the old Fram Oil Filter commercials used to say, “You can pay me now, or pay me later.”
Mutual fund investors paid $13.1 billion in 12b-1 fees in 2008.
Mutual funds also pass along their administrative costs to you. These are the costs of keeping records, maintaining customer service, mailing you reports, etc. Although they are necessary expenses, these costs can vary greatly from fund to fund.
What would a mutual fund be without a manager? All actively managed funds have an investment advisor making decisions about the stocks owned by your fund. The fee paid to the manager is generally up to 1% of the total value of the fund and is assessed once a year.
Fees Affect Returns
The mutual funds’ industry group, the Investment Company Institute, reports total assets held in stock mutual funds at the end of 2007 was more than $7.2 trillion. The average of expenses for mutual funds that held stocks was about 1.4%. That’s more than $100 billion in fees paid by stock mutual fund investors during the year.
John C. Bogle is the legendary founder of Vanguard, one of world’s largest mutual fund companies. He gave an interview to PBS’ Frontline program on February 7, 2006 in which he warned retirement investors against mutual fund costs and fees. Pointing out that these fees can consume a huge portion of your returns over the long term, he said, “…in the long run, it's 80 percent to the financial system, 20 percent to you.”
According to MarketWatch, mutual funds are increasing their fees this year. What does that mean to you? More money to the managers, less to you.
Bogle said, “That is a financial system that is failing investors because of those costs of financial advice and brokerage, some hidden, some out in plain sight, that investors face today…we have a mutual fund industry that has become a giant marketing system [where] the idea is to bring in the most money by fair means or foul.”
You Get What You Pay For, Right?
Many retirement investors believe they must use an actively managed mutual fund to get the best returns. But most mutual funds don’t beat the market, even in good times.
Quite the opposite: According to Morningstar Inc., the vast majority of mutual funds fail to keep up with the market averages. Add in the cost of fees and overhead, and you’re falling behind in bull markets.
Brett Arends, writing in The Wall Street Journal, puts it this way:
“The typical mutual fund, as we know it, is a failure. Most sock the customers with high fees. During the good years…studies show, about 80% actually under-perform the index.”
If most mutual funds fail to keep up with the market averages during good years, is that a fair price to pay for protection in tough times? Doesn’t active, professional management reduce market risk and the likelihood of loss? How do mutual funds perform in bear markets?
Here’s a brief comparison of performance for 2008:
The Dow Jones Industrial Average lost 33.8%.
Standard & Poor's 500 Index lost 38%.
Morningstar says actively managed stock mutual funds lost an average of 39%.
What’s worse, mutual funds as a group only make money in a bull market, because the rules require them to remain fully invested at all times. A typical mutual fund manager can’t sell everything, go to cash and wait for the next bull market. In a bear market, remaining fully invested all the way down is a recipe for disaster.
Of the thousands of diversified U.S. stock mutual funds available to investors in 2008, only one posted a positive return. That’s right, just one. The Forester Value Fund was up a measly 0.4% in 2008. Of course, past performance is no guarantee of future results. Forester Value Fund is down more than 10% year-to-date.
Bottom line: You are not protected from bear markets in a mutual fund. This is why the value of your retirement account plummeted in the last 18 months.
Even after paying billions in management fees, "…a lot of investors felt let down last year by active managers," said Paul Justice, an analyst at Morningstar.
Kevin Ellman, head of a financial-advisory firm, said, "We're more convinced than ever that active management is not worth the expense."
And from The Wall Street Journal once again, Brett Arends:
“The firms running these funds have access to unparalleled ‘talent’ and resources, plus billions of dollars a year in fees…
“Let it be said that 2008 was the year America's fund management industry was tested and found lacking. The managers' justification [for their fees]? That they would manage risk and provide some shelter in a financial storm.
“In 2008, the Standard & Poor's 500 index fund fell about 38%. Active managers? On average they lost 39%. Large cap, small cap, growth, value, ‘blend’—all styles flopped.
“But for the industry overall: It under-performed for decades, then failed to manage risk just when that was needed.
“So much for that.”
Take Control Now
It may not be your fault that you were so unprepared for the bear market, but it is your fault if you do nothing now to change how you prepare for the future. There are a few simple keys to change the results you get in the markets:
1. Eliminate the mutual fund mentality from your investing. Mutual funds will not meet your investing needs.
2. Take a careful look at what has happened to your retirement account value, then set new goals for the future.
Whether you realized it or not, your retirement goals were built on the expectation that stock markets would always go up. How can we say that? Look at your investments. You are loaded up on mutual funds; they only make money in bull markets. But markets don’t always go up. Both 2001 and 2008 should be clear reminders of that.
It’s time to revisit your assumptions, factor in how much you have lost, and adjust the average annual rate of return you need to make with the money you have available to invest today.
3. Take action to realize your new goals.
Learn what you need to know to invest properly. For investing in today’s markets, an Exchange Traded Fund (ETF) is probably a better fit for you.
ETFs have many advantages:
ETFs can be used to make money in any market, bull or bear.
ETFs don’t have the high management fees and overhead expenses of actively managed mutual funds.
ETFs trade like stocks, with the ability to use stop loss orders and/or options.
But with ETFs you don’t have to sort through tens of thousands of publicly traded companies, learn how to analyze annual reports and quarterly statements, then spend hours checking and re-checking your numbers to make sure you picked the right stock.
On any day, at any time, with ETFs you can choose whether to be in or out of the market and take complete control over how you participate in the stock market.
In future articles we will discuss these topics in further detail and help you start a game plan to reach your investing goals for retirement.