Death of the Mutual Fund

December 30, 2014 Posted by admin

For many decades the core investment of most individual accounts, 401ks, and IRAs has been the mutual fund. Various structures of loads, annual fees, or 12b-1s may exist but the main concept has stayed the same. This involves the computation of the fund’s NAV (Net Asset Value) on a daily basis with the gain or loss being posted shortly after the market close. In my opinion, this concept will soon go the way of fractional stock quotes due to the emergence of ETFs (Exchange Traded Funds), where efficiency and management effectiveness can be factored into the price.

ETFs are much more efficient than traditional MFs. Most traditional mutual funds have to keep a percentage of the fund’s assets in cash to handle redemptions. This hurts the performance of the fund since investors pay fund managers to invest in companies, not cash. Having to keep cash on hand to deal with this “redemption burden” is one reason that the majority of all mutual funds underperform the S&P 500 each year. Some funds would combat this by having their funds “closed” for most of the year, and only “opening” their funds at a few specific dates for new investor money and redemptions. This is plain scary as many people have recently learned the value of liquidity the hard way due to mortgage or other financial problems. “Penned-up” capital gains have also caught many investors off guard. When investors purchase the recent “hot performing” fund or buy a mutual fund after a market upswing, many do not realize that they are buying into this fund’s capital gains also. Getting a large unexpected capital gain distribution from a recently bought mutual fund can be frustrating and add uncertainty to your tax planning strategies.

How is management effectiveness priced into an MF? In the case of traditional mutual funds, the simple answer is that it is not. Investors have to rely on ratings from Morningstar, Value Line, or even promotional material from the fund itself to evaluate management effectiveness since the fund’s bid price is almost always based on its NAV. Manage effectiveness, like stocks, are best evaluated on a free market basis. Since ETFs trade just like a stock on an exchange, their premium or discount for management effectiveness is factored directly into its trading price.

More and more often I find myself recommending ETFs to my clients instead of mutual funds. I realize that I won’t be getting any all-expense paid trips to some Caribbean island where many mutual fund companies take their top producing brokers for “due diligence meetings”, but I would rather keep my integrity and bring higher performance to my clients instead. The only time I still consider buying a traditional mutual fund for a client is when I am planning for a long-term purchase, with a well-respected fund manager, and no potential needs for liquidity for several years.

Arthur Kaplan invites you to visit http://kappatrade.com to learn more about the stock market and what the financial world is currently undergoing. Feel free to write us directly on our website for any help and/or suggestions.

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