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If you are planning to have investments in mutual funds, here are 5 things you must know before investing.
1. The majority of mutual funds underperform the stock market
Historically the majority of mutual funds continue to underperform in terms of growth in the stock market; this is partly due to their cost overhead, and the strategies employed by their fund managers.
“Over time, because of their costs, approximately 80% of mutual funds will underperform the stock market’s returns.”*
“Over the past five years, fully 91 percent of all mutual funds have underperformed the market’s average return.”**
2. Good fund managers are lured away by other mutual fund companies
There are only a handful of great fund managers; the problem is all of the mutual fund companies wish they had those great managers working for them. Mutual fund companies hire away the best managers from competing companies in order to raise their own performance and gain customers. But when a great fund manager leaves, the performance of their mutual fund usually suffers resulting in losses for you.
It is difficult to know when your mutual fund manager has been replaced and where he or she is now working. As a mutual fund investor it’ll be nearly impossible for you to follow the fund manager with your money without incurring costs along the way.
3. When a lot of people start withdrawing money from their mutual funds, all fund owners suffer
When markets are down, people panic and start calling their mutual fund company to redeem their mutual funds for cash. At this point the fund manager has no choice but to sell the stocks/bonds in order to return the cash to the mutual fund owners. Even if the fund manager believes that the stocks should not be sold (because for example the stocks are not yet overvalued, or the stock price may rise in the next 6-12 months) he or she has to sell the shares when customers start asking for their money back.
When a stock is sold prematurely the losses are solidified and the entire fund suffers, even the customers who decided not to redeem their mutual funds will see their portfolios drop in value.
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4. Even if you don’t sell your mutual funds, you’ll still pay taxes any capital gains
Outside of your retirement accounts (RRSP, 401k) you generally have to pay taxes on any interest, capital gains, or dividends earned. When the mutual fund incurs a gain, the gain is distributed among the mutual fund owners. As a mutual fund holder you will have to pay taxes on any of those gains even if you did not redeem any mutual funds that year.
With stocks, you only pay taxes (outside of your retirement trading account) on the capital gains when you sell the stock.
5. All mutual funds have fees, including index funds
All mutual funds have a fee called the Management Expense Ratio (MER). The MER helps to pay for the mutual fund employees, expenses, office space, administration, and marketing budgets.
Speaking in Toronto on December 4, 2000, John C. Bogle, founder of the Vanguard Group, presented, in great detail, data to prove that “mutual fund investing is an expensive home to long-term investors.” $1,000 invested 50 years ago in the S&P 500 would have grown to $514,000. However, with fees (MER) of 2.2%, financial intermediaries would have taken $321,000 of the sum leaving only $193,000 for the investor. Bogle used the word “shocking” to describe this loss of 63% of the market’s cumulative return to the intermediaries.
Bonus #6: What They Really Don’t Want You to Know!: The Solution
The main solution is simple, avoid paying any fees, and learn how to invest in quality companies on your own. Manage your own portfolio instead of losing 63% of your money over your lifetime to the mutual fund companies. First transfer your RRSPs to a brokerage and then take control of your investing decisions. Investing on your own can be simple, quick, less risky, and more rewarding!
Author Bio: Kanwal Sarai, is the founder of Simply Investing, and on a quest to bring financial freedom to all. He created the Simply Investing Online Course on the belief that the world can be a better place if people didn’t have to worry or stress out about money. Simply Investing’s goal is to make investing easy, save you time, and help you safely earn more.
** Page 260, “You Have More Than You Think”, David Gardner