Mutual fund managers have the job of managing their mutual funds. They do not have the job of doing what's best for each individual client. While they are tasked with managing their funds to get the best gain possible within the scope of their fund's parameters, they are often tasked with being at least 90-95% invested at all times. Even if a fund manager sees a bear market starting, he is required to stay invested in the stocks his fund targets. This is a disadvantage for their long-term performance. Markets cycle through sector rotations. Fund managers who cannot adjust with the cycles have a disadvantage. This disadvantage turns into a sub-par longer-term performance for the investors who invested blindly in these funds.
Some mutual funds give their managers leeway to diverge from their mandate. While this can be beneficial to the fund's longer-term performance, investors can be left under-invested without their knowledge. Mutual fund managers are graded on a quarterly and annual basis. These short-term horizons might not be in the best interest of individual investors. An investor who has a 20-year time horizon might be willing to weather the ebbs and flows of the market and would like to stay fully invested to avoid unexpected capital gains and taxes. Other investors might liquidate (sell) other mutual funds to create their own cash position, not knowing that their remaining mutual funds did the same. These uninformed investors are left with little market exposure when the bull market resumes.
Index ETFs (Exchange Traded Funds) can be a better alternative in both situations. Passive investors only have capital gains when they sell their ETF shares, not with the fund changes investment allocations. Investors who want to rebalance their allocations will always know the correct percentages invested in each sector, including cash.
Active investment advisors have the freedom to remove funds from all equity investments and move into cash when economic cycles or market conditions dictate. Fee-only investment advisors have no vested interest in which investment vehicles are used, so they are able to manage clients' portfolios without any outside influence that does not best meet the needs of each client. A good investment advisor will consider each individual client's objective, risk tolerance and tax situation before making changes to stock and bond allocations. Mutual funds only focus on their fund's goals, not the investors' goals. The fund's goals and the investor's goals do not always match.
I pulled a few lines out of some of the most popular mutual fund prospectuses to highlight the difference in using these funds versus ETFs.
From Fidelity, Contrafund prospectus:
"Fidelity Distributors Corporation (FDC), and/or their affiliates may pay intermediaries, which may include banks, broker-dealers, retirement plan sponsors, administrators, or service-providers (who may be affiliated with the Adviser or FDC), for the sale of fund shares and related services. These payments may create a conflict of interest by influencing your intermediary and your investment professional to recommend the fund over another investment."
Fidelity clearly states that they are paying advisors to have them invest in their funds and creating a "conflict of interest". These fees are paid on top of any wrap fees or management fees paid by the client directly to the advisor. Often, investors do not realize their advisors are biased towards certain funds because they have a vested interest in it, not because the funds are best for the individual client's needs. This is better for the fund and advisor, not the investor.
From American Funds, The Growth Fund of America prospectus:
"The fund may also hold cash or money market instruments, including commercial paper and short-term securities issued by the U.S. government, its agencies and instrumentalities. The percentage of the fund invested in such holdings varies and depends on various factors, including market conditions and purchases and redemptions of fund shares. For temporary defensive purposes, the fund may invest without limitation in such instruments."
In other words, you might think you've invested in a stock fund, but you may own cash or short-term bonds. On top of not knowing how your fund has invested, Class A shares have a "Dealer commission as a percentage of offering price" up to 5.75%. This means that on the day you buy this fund, you start with 5.75% less than you originally invested. This up-front sales charge is in addition to the fund's 0.70% expense ratio and 0.24% 12b1 (aka marketing) fee.
From Dodge and Cox, Stock Fund
"Fund will invest at least 80% of its total assets in common stocks..."
This fund is the opposite of the Fidelity fund referenced above. The Stock Fund must stay 80% invested at all times. This could be good or bad for the individual investor and either way, it's not based on the investor's individual situation. Such details are easily found in every mutual fund's "Investment Strategies" section in their prospectus. Individual investors will be hard pressed to find mutual funds that meet their personal needs because their fund managers are not looking out for you.
