Reasons not to Invest in Mutual Funds

There are literally thousands of mutual funds today, and they have become the most popular tool of choice for non-professional investors hoping to save their money for retirement. At the same time, for some people there are still reasons not to invest in mutual funds. Mutual funds may be unadvisable for people who want to try their hand at actively trading in the markets (not usually a sound investment strategy, but potentially exciting and enjoyable), or for people who are extremely concerned about taking risks with their money and may prefer more stable and secure investment options. In addition, and perhaps most importantly, many personal finance writers currently argue that actively traded mutual funds are, on average, unlikely to produce better returns than passive index funds.

– About Mutual Funds –

Mutual funds exist, in essence, to provide inexpensive diversification options for personal investment portfolios. Historically, investing in equities (stocks) is the best way to earn income over the long term, especially when combined (for safety’s sake) with some amount of investment in bonds as well. However, the average individual investor could not afford to buy more than a miniscule fraction of the total number of stocks on a major index – say, the Standard & Poor’s (S&P) 500 – at a time. Mutual funds offer the opportunity to invest in a large number of companies at minimal cost, by pooling one’s money with the rest of the investors in the fund.

An actively traded mutual fund has a professional manager who makes investment decisions in exchange for a commission, which, along with various other fees, will often be about 1-2% of the total value of the mutual fund each year.

– Active and Passive Funds –

The first and most important reason not to invest in a traditional, actively traded mutual fund is the argument raised by an increasing number of personal finance writers: namely, that active mutual funds are not a reliable way to “beat the markets.” An actively traded mutual fund actually combines two objectives: first, inexpensive diversification by pooling resources with others to invest in many companies; but also, benefiting from the guidance of a professional fund manager who moves money between investments.

In practice, however, diversification does not necessarily require the presence of active management. One could, for example, invest in every single publicly traded company in the world – or, more practically, one could invest in all of the companies on an important index, like the S&P 500 (which tracks American companies), the S&P/TSX 60 (which tracks Canadian companies), or Morgan Stanley’s MSCI EAFE (which tracks European, Australian, and Far Eastern companies, and is considered an “international” index by North American investors). Many personal finance writers now argue that only a minority of active fund managers are actually capable of reliably producing greater results than someone could obtain simply by investing in all of the companies on the index, due to the combined consequences of holding comparatively large cash reserves (earning essentially no income), charging more money to management income and to brokerage fees (leading to high annual expense ratios), and, in general, the inability of even well-trained humans to accurately predict in every case which companies will succeed and which will fail.

For those who share this skepticism about the basic reliability of the majority of the investing industry, fortunately, there are alternatives. Alongside the traditional active mutual funds, a growing number of passive index funds and equity-traded funds now exist. Index funds, instead of actively buying and selling a large number of investments, simply buy into all of the companies on a given index (say, the S&P 500) and follow that index up or down. The disadvantage is that, in a market downturn, a passive fund will not react as an active manager has the option to, by switching to safer investments. The advantage is that, in the long run, the index as a whole grows faster than the average mutual fund.

– For the Risk-Averse –

In addition, for some people there is an additional reason not to invest in mutual funds: even these diversified investments are simply too stressful to hold. People who prefer to avoid any real risk at all with their hard-earned savings (a position known as “risk-averse”) may find even mutual funds simply too stressful or too risky to be worth investing in. Mutual funds are government-regulated, but they are not government-insured through FDIC, as savings accounts and certificates of deposit (CDs) are. (The same is true in other countries: in Canada, for example, GICs are insured but mutual funds are not.)

Moreover, although in the long run the markets (and the mutual funds which track them) have always grown, in any given period they may not grow at all – and, in a recession, they may actually shrink significantly. Investing in a mutual fund involves taking on some amount of risk in exchange for the promise of a potentially greater rate of return. However, people who want to eliminate risk entirely may prefer to avoid mutual funds as well, seeking out high-interest savings accounts or locking their money into term deposits. These will generally not earn as much interest in the long run, but at least they are insured, and you can always be certain that the interest rate set in advance will be adhered to by the bank.

– For Risk-Lovers –

In addition to the risk-averse, however, there are people on the other end of the risk spectrum who may also want to keep at least some of their money out of the mutual fund industry. Mutual funds are, in essence, for people who want to lock away money and let it grow for a long time, in most cases until they retire. However, it is undeniable that for many people actively trading in stocks can be enjoyable, exciting, and sometimes even very profitable. People who want to actively move their money around the markets should be aware that for an untrained amateur trader, the likely rates of return are negligible at best and highly negative at worst. Nevertheless, people seeking the excitement of the markets probably will not find that excitement by buying into mutual funds, and should plan their investment activities accordingly.

Overall, both actively traded mutual funds and passively traded (index-based) mutual funds are very strong investment tools for people who want to lock their money away and let it grow for the future, perhaps with the advice of a financial advisor in the meantime. Nevertheless, there are legitimate reasons not to invest in mutual funds, especially for people who prefer to avoid any significant risk even if it means accepting lower returns.