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A lesson in mutual funds

| Wednesday, Feb. 6, 2013, 12:02 a.m.

For most Americans, their biggest assets, besides a house, are qualified retirement plans.

These may be 401Ks, IRAs or a Roth. Since these are only tax structures, you must have an underlying investment. These are often mutual funds. Some people also own non-qualified mutual funds. This is when you buy them with after tax savings. Many people do not understand the internal workings of these funds.

Mutual funds are sold under the premise of professional management, diversity for the small investor and as a way to make small contributions over time. A fund may be either actively managed or indexed. Actively managed funds attempt to beat the averages and are more expensive to own. Indexed funds try to duplicate the performance of an index such as the S&P 500. They simply buy all of the stocks in the index in the proper weighting. They adjust their holdings as the index changes. Because they are just copying the index, they have lower fees.

Sometimes either method can produce the best results. The most important consideration to the investor is return after costs and taxes. Index tend to do best when the whole market is rising. Actively managed can do better in either type of environment depending the skills of the manager. There are thousands of mutual funds from which to choose. Some can invest in anything and some are sector funds that might invest in certain countries, energy or any other specified area.

Jack Bogle, founder of Vanguard Group, predicted in August 2012 that in 15 years half of all funds will have disappeared. A study done by A Random Walk Down Wall Street reports that two-thirds of mutual funds under-perform annually and that no mutual fund, with more than $1 billion, outperformed the market during the last 10 years. That is more funds than you would imagine.

Mutual funds of all types have many expenses that other investments do not. They must fund a board of directors, auditor, administrator and accountant. According to Morningstar, U.S. stock funds annually average spending 1.31 percent of assets to cover portfolio compensation and other operating expenses. There are also many hidden costs for using mutual funds. Whenever an investor wants to redeem some of his investment, the manager must sell some holdings to get the money to pay the redemption. Every buy and sale creates a ticket charge. Sometimes managers accept soft dollar deals where they pay more ticket charge to receive free research. Fund managers do not have a real incentive to keep these costs down. A cost for funds that many people do not consider is market impact cost. If you are buying or selling 100 shares of a company, you will have very little influence of price fluctuations on Wall Street. If a fund company is buying or selling 300,000 shares it can have a big impact. Since the market is an auction, buying large amounts could cost more and selling large amounts could lower the return.

There are several more ways that mutual funds are expensive investment vehicles. If you own a variable annuity, you own the funds in a very expensive wrapper. You pay for elements of both an annuity and the mutual fund. Many people do not understand these costs of riders and may be getting no benefit. Funds inside of a qualified plan often have many more fees. There are new disclosure laws taking effect soon to deal with possible abuses. Also if your broker only will sell you funds owned by their company or on a preferred list, you may not be getting the best selection or price.

Next week, we will look at some other issues dealing with mutual funds.

Gary Boatman is a certified financial planner and local businessman who serves as president of the Monessen Chamber of Commerce.

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