The Appeal of Mutual Funds
Once the idea of mutual funds took off, brokers no longer had to shoulder all of the weight of these decisions, and they could instead point to industry experts who had vast resources and training and knowledge to direct the investments of their clients.
This idea became very popular with clients, as they saw themselves taking advantage of world class investment management, which at that point had been limited to those of very significant means. They could acquire this high level of management at only a fraction of the cost of dedicated investment management, by pooling their resources with many others and enjoying the economies of scale that resulted.
This seemed like a perfect solution for individual investors, and mutual funds then became extremely easy to sell to clients. It was just all about finding out what the client’s needs and goals are and then matching them to the right mutual funds. Often the mutual funds offered were those of the firm’s, but no matter, provided that the funds matched the clients.
While mutual funds do involve management fees, apart from the actual buying and selling of securities, individuals were told that there is no free ride here and if they bought and sold the securities themselves, they may not have enough resources to do so and even if they did, this would involve much higher costs.
The fact is, if individual investors tried to buy all of the components of a mutual fund, the great majority of mutual fund investors would be unable to do so, because there are minimums that need to be met for each. There also would be trading costs for each trade involved, adding up to a lot of money.
Mutual funds, by pooling resources, allow for literally thousands of components, which are promoted to add a lot more diversity and therefore better protect investors against risk. This is true to some extent at least, although diversity among a given asset class such as stocks do tend to be overstated by mutual fund promoters, as most stocks decline during bear markets for instance.
If the fund being promoted is a managed fund, promoters and sales people can also point out that those who are making the decisions are professionals, who have far more knowledge and access to information than the individual investor, which is of course true.
So we have two big benefits here, the fact that one can diversify and one can also have their portfolio professionally managed, and all they have to do is sign to have all of these benefits available to them.
Mutual Funds Have Simply Taken Over the Market
There are still people who invest on their own, as well as some who do have their assets professionally managed, but the great majority of individual investors now invest in some type of fund or other, whether that be mutual funds, exchange traded funds, or hedge funds.
Among those investing in funds, mutual funds dominate the marketplace. This is mostly because mutual funds have virtually monopolized the financial advisor experience, where the only decision that can be made is which mutual fund or funds to invest in.
When you visit an advisor and all they sell is mutual funds, you are either going to be investing in mutual funds or you won’t be investing in anything. While it is true that some advisors also offer products like CDs which do not involve buying mutual funds, particularly those who work for banks, and those selling insurance as well are going to be offering insurance products, mutual funds simply dominate the investment frontier these days.
Alternatives to Mutual Funds Really Aren’t Part of the Discussion
The focus for mutual fund sales people is looking to decide on the appropriate mix of the different asset classes and sectors that mutual funds offer, and the decision never really comes down to whether an investor should invest in something else other than mutual funds, and even if they should invest part of their portfolio in something else.
Clients see these advisors as actual advisors, out for their best financial interest, and the fact that they are generally nothing more than mutual fund sales people escapes them, because that’s how ubiquitous mutual funds have become these days.
For many clients, mutual fund investing and investing are one in the same, at least as far as sensible investing goes. They could always forage off on their own and build their own portfolios, but they do tend to realize that, at least with their present state of knowledge, that would be a recipe for disaster and clearly an inferior approach to leaving all of this up to the pros who actually are presumed to know what they are doing.
In actual fact, one could build a portfolio by throwing darts and beat the majority of mutual funds, at least in terms of performance, and in fact most mutual funds do not beat index averages, and by extension, probably not a random selection of stocks either.
It simply costs more money for mutual funds to select and move in and out of stocks to put these allocation decisions into action, and the cost does tend to be higher than the benefits. This does not mean this is the case with all managed mutual funds, but only about 1 in 5 beat the market and justify their higher management fees.
Hedge funds do tend to beat the averages by a healthy amount, even after their much higher fees are taken out, mostly consisting of high commissions such as 20% of one’s gains.
Due to the way hedge funds are regulated, they are out of reach of most investors, and we may wonder what influence the mutual fund industry has in keeping these regulations in place, given that their performance is considerably more inferior and their risk is also considerably higher, and they would no doubt lose a lot of business if the doors to hedge funds were opened to all.
Exchange traded funds have really grown in popularity over the last few years, which are essentially funds that can be traded by individuals on exchanges. Most investors aren’t too familiar with ETFs though, at least enough to want to jump in and start picking their own funds, and this does require at least some skill to pull off successfully and beat returns that mutual funds deliver.
Investors Don’t Like to Be Too Involved
You won’t get a pitch to go off on your own from a mutual fund advisor though, any more than you would expect a car dealer to talk you out of buying a new car, because selling mutual funds is what these people get paid to do.
When it comes to seeking out investments, many people prefer it as easy as possible. If you can just meet with your advisor, and have them sell you some investments, and just keep the investments until you retire, that’s seen as pretty ideal by many actually.
This is also ideal for mutual fund dealers as well, as this allows them to gain and keep a client’s portfolio under their management and look to grow it over time by simply having clients keep contributing to the same funds. Dealers don’t even want people thinking about switching funds, let alone thinking about alternatives to mutual funds, so the buy and hold approach has become almost like a religion in these circles.
Beyond this, investors have to contribute to the decision making process at least to some degree to seek out alternatives to just doing what you are told here by the sales people. If people complain about their returns not being as good as the market, they can instead be sold index funds, where now all of the blame can be placed upon the market and none of it on the fund or the fund dealers.
This is a perfect situation for dealers actually and the growth of index funds hasn’t been as much as investors demanding index funds as dealers promoting them. Buyer remorse has always been a big issue for mutual fund dealers, and people will even unfairly blame fund management during bear markets, and ultimately blame the people who sold them the funds, the dealer and their advisors.
If this blame can be focused instead on the market, and being in the market is seen as required, then this both simplifies the selling of mutual funds and also greatly reduces client turnover. If the market is down, it can’t be the fault of your advisor, so finding another one no longer makes sense.
If you’re planning on investing in the long term, things like exchange traded funds and their benefits can be minimized, as the fact that you can’t get out of your position until the next day shouldn’t matter if you’re holding for many years, as you should. While index funds do have management fees that are a little higher than some exchange traded funds, the difference isn’t all that significant usually, and after all, you do have people to go to rather than just trading on your own on a computer.
Many investors aren’t really that tech savvy anyway and may not even have heard about ETFs, so while ETFs have taken away quite a bit of the business away from mutual funds, at least at the present time, mutual funds have such an empire and such an army of promoters that they aren’t going away anytime soon.