A mutual fund is where a fund manager takes money from many investors and invests it in stocks, bonds, short-term money market instruments, and/or other securities.
The fund manager then trades on these investments, with the view of increasing their value and passing a dividend onto the individual investors.
The main criticism of mutual funds is that they tend to underperform when compared to index tracker funds. David Swensen, who has headed up Yale University’s endowment fund for 20 years, has this to say about mutual funds:
‘Soft money, fees, overtrading, market timing, and other management practices lower performance and virtually guarantee that most mutual fund returns will fall short of their benchmark, such as the S&P 500. Furthermore, for-profit mutual fund companies have a fiduciary obligation to their stockholders, not to their investors, and this relationship “inevitably resolves in favour of the bottom line.” (*)
(*) Taken from Motley Fool ‘Funds are failing us’ article, http://www.fool.co.uk/stockideas/2005/si051116.htm
Some of the reasons why mutual funds are a poor choice include:
1) They rely on the ability of a fund manager to out-think the market. Experience shows that many underperform, and those that outperform usually can’t do so consistently and to an extent that justifies associated fees. One study found that nearly 1,500 U.S. mutual funds under-performed the market in approximately half of the years between 1962 and 1992(*)
(*)Mark Carhart (March 1997). “On Persistence in Mutual Fund Performance”. Journal of Finance
2) Fund managers may feel the need to trade regularly to justify their role. Regular trading, though, incurs costs and undermines long-term returns.
3) There is a management fee and sometimes other fees apply
4) Conflict of interest over commission fees. Commission fees benefit the finds manager but not the investors.
In conclusion, if you’ve got money to invest, you need to consider whether the managed fund is likely to outperform a tracker fund once costs have been taken into account.