Times are tough for the nation's leading mutual funds.
Net results are weak and could get even weaker, making this a bad time to commit new money to traditional mutual funds.
For several decades, mutual funds have seemed like a bad investment -- at least when compared to their cousins, the index funds.
Top mutual funds may do alright in terms of stock picking, but almost inevitably, high management fees and sales expenses rendered them uncompetitive against a traditional index fund like the Vanguard S&P 500 Index fund (Nasdaq: VFINX).
For example, the Vanguard S&P 500 Index Fund charges just 0.17% in annual expenses, compared to the popular mutual fund Legg Mason Capital Management Value Fund (Nasdaq: LMVTX), which carries a sales load of 0.95% and an annual expense of 1.76%.
It's bad enough that higher expenses take a steadily bigger bite over many years, but performance can be weak as well, adding insult to expensive injury. The aforementioned Legg Mason fund has lost an average of 2% in the past 10 years, according to Morningstar.
And now mutual funds have a new competitor in the exchange-traded fund (ETF). Like index funds, ETFs have low expenses while allowing for more targeted investments.
If you're bullish on copper, then you can simply buy a low-cost, copper-focused ETF like First Trust ISE Global Copper Index (NYSE: CU) instead of a broad-based commodity fund offered by the mutual fund firms.
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2. More and More Investors are Avoiding Mutual Funds
Investors are starting to pick up on the relative weaknesses of mutual funds, especially those focused on stocks rather than bonds, so they've been pulling money out at a steady pace. According to the Investment Company Institute, more than $335 billion has been withdrawn from domestic equity mutual funds over the past four years.
Index mutual funds, on the other hand, have grown in popularity over the same time period: investors pumped more than $210 billion in them since 2007.
When a mutual fund investor wants to sell funds, the fund manager is told to raise cash to meet client redemptions. To raise cash, they need to sell stocks. And when they sell stocks, they hurt the prices of the very equities they own.
Of course, the converse is also true. Mutual funds can generate great results when they receive fresh client funds because they can load up on key stocks. This is why tech-focused mutual funds did so well in the late 1990s -- everyone wanted a piece.
Mutual funds poured money into Cisco Systems (Nasdaq: CSCO), Dell (Nasdaq: DELL) and others, sending prices higher and higher. But with the advent of ETFs and the ongoing popularity of index funds, it's not clear we'll ever see such a positive flow into mutual funds ever again.
3. Mutual Funds Aren't Beating the Market
Investors may also be souring on mutual funds after realizing it's almost impossible to outperform the market for a long period. Bill Miller was able to do it at the Legg Mason Capital Management Value Fund from 1991 through 2005 -- a feat that's virtually unparalleled in the modern era.
But Miller's fund has trailed the S&P 500 in four of the past five years.
As another example, Fidelity, one of the nation's top fund firms, has always sought to place its sharpest managers at the helm of its flagship Fidelity Magellan Fund (Nasdaq: FMAGX). The firm was able to beat the indexes throughout much of the 1980s and 1990s, thanks to Peter Lynch.
But if you invested in Magellan at the start of 2006, then your money's performance would be virtually flat. The S&P 500 would have at least gained 12% in that time.
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The Investing Answer: The mutual fund industry is at a crossroads. If you own existing funds with reasonable expenses, there's no reason to rush out and dump them. But these funds should no longer be the first place you park your new investment dollars. Until the fund industry solves the perennial problems of high expenses and poor performance, index funds and ETFs are the better bet for your money.