For many Americans, investing in mutual funds is their primary, or perhaps only, way of saving for retirement. This means their sole exposure to the stock market, one of the greatest methods of wealth creation, is through fee-driven funds over which they have little control.
Throughout the last 20 years, total mutual fund net assets in the U.S. have grown from $5.53 trillion to $18.75 trillion.
Much of this asset inflow can be attributed to the prevalence of the 401(k) in employer’s retirement options. Most people, however, are unaware that they may be able to request what’s known as an “in-service distribution,” which allows them to rollover funds from their 401(k) to an IRA. This allows for more investment options and gives investors more control over their assets, with the ability to invest in index funds or pick individual stocks.
I previously wrote about the pros and cons of active versus passive management in bond funds, but for the scope of this article, I’ll be solely discussing the equity market. Here are four ways in which an individual investor has a distinct advantage over mutual funds:
SECTOR ROTATION & REBALANCING
Mutual funds and ETFs must maintain a certain weighting in their portfolios based on their prospectuses. That means that either quarterly or annually, they must rebalance their portfolio regardless of their beliefs on the prospects (or lack thereof) of the stocks that constitute their portfolio.
Also, when there’s a sentiment shift from analysts or institutions on the short-term outlook of a certain sector, most of the other stocks in that sector get rewarded or punished accordingly. As we’ve seen recently with technology stocks over the past several months, privacy concerns and slowing growth have had a negative effect on multiple stocks within the tech sector.
In a rising interest rate environment, a common institutional strategy is to rotate away from consumer staples stocks whose high dividend yields act as bond proxies. The yields on these stocks seem less attractive when a mostly risk-free investment in Treasuries sees an increase in yield.
As an individual investor, you can pick and choose the good ones that are unfairly hurt by this rotation and rebalancing and can buy and sell individual stocks based on your beliefs about their long-term outlook.
Funds are driving the market through preprogrammed passive investing strategies that ignore something very important: the underlying fundamentals of these companies haven’t changed. A savvy investor can spot these market inefficiencies and jump at a potential opportunity to buy a good stock on sale!
TAX EFFICIENCY & FEES
Holding mutual funds in a taxable account might spell disaster when you get your tax bill in April. Even if the fund declines in value, you’ll still have to pay taxes on the distributions you receive.
If a mutual fund sells shares of a stock it has held for less than a year, you may be subjected to short-term capital gains taxes, regardless of how long you’ve held shares in the mutual fund. If this fund is held in a taxable account, the distribution will be taxed at your ordinary income rate instead of at a preferable long-term capital gains rate.
In their Target Date Funds prospectus, Vanguard illuminates the disadvantages of what’s known as “buying a dividend,” or buying fund shares right before a distribution date:
Unless you are a tax-exempt investor or investing through a tax-advantaged account (such as an IRA or an employer-sponsored retirement or savings plan), you should consider avoiding a purchase of fund shares shortly before the fund makes a distribution, because doing so can cost you money in taxes. This is known as “buying a dividend.” For example: On December 15, you invest $5,000, buying 250 shares for $20 each. If the fund pays a distribution of $1 per share on December 16, its share price will drop to $19 (not counting market change). You still have only $5,000 (250 shares x $19 = $4,750 in share value, plus 250 shares x $1 = $250 in distributions), but you owe tax on the $250 distribution you received—even if you reinvest it in more shares. To avoid buying a dividend, check a fund’s distribution schedule before you invest.
While most people hold Target Date funds within a tax-advantaged account (like a Traditional or Roth IRA), this information can be applied to any other mutual fund that makes a distribution.
Many passive funds charge low fees, but fees on some actively managed mutual funds can be over 2%. Over time, those fees will significantly dampen your long-term returns and could possibly delay your retirement. Fees can be masked or overcomplicated so you don’t even understand what you’re paying for. Load fees, fees for buying, fees for selling, fees to cover promotional material — not all of it is clear and upfront.
LACK OF LIQUIDITY & CONTROL
Mutual funds are not as liquid as stocks and only trade once a day based on their Net Asset Value (NAV). The NAV is calculated based on a fund’s net assets (assets minus liabilities) and then divided by the total number of shares outstanding.
If you want to buy or sell shares of a mutual fund, your trade will be executed after the market closes at the next available NAV. Keep in mind that some funds will also charge you a fee for buying into or selling out of their fund.
ETFs are more liquid and can be traded throughout market hours, however consistently trading in and out of ETFs can have significant tax ramifications.
The robo-advisor Betterment came under fire for halting all client trades after the Brexit vote in June 2016. Savvy investors who wanted to take advantage of buying low or panicked investors who wanted to liquidate their holdings in fear of a crisis were unable to make any transactions within their portfolio.
Wouldn’t you rather have control over your money at all times?
CAN’T CONCENTRATE WITHIN YOUR POSITIONS
I previously wrote how some of the best investors don’t believe in diversification. If you think a certain stock is trading at a bargain, you can load up and buy as many shares as you like within your portfolio. If you’re correct and the stock skyrockets, your portfolio returns will reflect that.
You can’t do that within a mutual fund. As discussed earlier, mutual funds have to rebalance if they get too concentrated in one stock or one sector. They are beholden to their prospectus, regardless of their outlook on a certain stock or sector. Sometimes that means they will make moves that you don’t agree with.
A mutual fund manager can be in charge of billions of dollars within a fund. If the manager winds up having a style you’re not comfortable with, you’ll have to completely sell out of the fund.
If you own several stocks within your own portfolio and you don’t like the management of a particular company, you can just sell out of your position and allocate your cash however you choose.
Many investing mistakes happen due to chasing performance — inflows come in at the high and might leave at the low. Investors not only chase performance but also tend to flock to well-known active managers or five-star rated funds. The problem is that just because a fund performed well in the past does not mean that its performance will continue into the future. Funds might be really good one year and really lousy the next. There’s a reason that every investment product contains the disclosure: “Past performance is no guarantee of future returns.”
Of course, just because you may have some advantages as an individual investor doesn’t mean you’re going to beat the market. Having control over your money and investment decisions means you’re responsible for your own outcomes. The success or failure of your portfolio falls solely on your shoulders.
Most people are not willing to take on that responsibility and prefer trusting their money with an active mutual fund manager who may or may not beat the market. Many are comfortable with average returns found by investing through index funds.
For the individual investor who goes it alone, there will be more work and perhaps more risk involved, but if you’re successful and can use these advantages to your advantage, the rewards can potentially be much greater.