Most stock mutual funds are thoroughly mediocre. But they are still better than the alternative.
Lately, it has become popular to trash mutual funds. More and more, I hear investors dismissing mutual funds as a starter investment and saying they plan to graduate to individual stocks. Similarly, financial planners, eager to offer their clients the aura of exclusivity, have begun eschewing funds in favor of private money managers.
This backlash isn't surprising. Too many stock funds charge too much, return too little and pay scant attention to taxes. Nevertheless, mutual funds remain the best bet for most investors. Here's why:
LESS STRESS: Experts tell us to put together a diversified collection of investments and then focus on the entire portfolio. The reality, however, is that investors tend to fret about their poor-performing investments, even if the rest of their portfolio is doing fine.
By dumping stock funds and buying individual stocks, you take this stressful situation and make it worse. After all, individual stocks perform far more erratically than funds. In addition, you will probably end up with a larger number of separate investments, which means you will have more potential causes for concern.
LOWER RISK: The fewer stocks you own, the greater the chance that your portfolio will be torpedoed by one or two rotten stocks. That is a real danger for those who stick solely with individual stocks.
It isn't, however, a problem for stock-fund investors. Many funds own between 30 and 300 stocks. And many investors own three funds, four funds or even more. These investors might have exposure to as many as 1,000 stocks. Given that diversification, it is unlikely that any one stock will cause severe damage.
KEEPING UP: Most years, the return of the Standard & Poor's 500 stock index is skewed upward by a minority of stocks that post explosive gains. Meanwhile, most of the index's constituent companies lag behind the average. If you don't own some of the stellar performers, your results will badly trail the S&P 500.
That is a distinct possibility if you avoid funds and buy individual stocks. Let's say you usually buy 100 shares of any one company, and the typical stock price is $50. Even if you have $100,000, you will be able to buy only 20 stocks. With that thin spread of companies, you may end up with little or no exposure to the winning stocks that are driving the S&P 500's gains.
STEPPING OUT: Of course, there is a lot more to the market than the S&P 500, an index of blue-chip stocks. What if you want to diversify into small companies and foreign shares, as many experts advise? For all but the wealthiest investors, funds are the only sensible choice.
COMPARE AND CONTRAST: You can easily find out how your funds have performed. All you have to do is look in the newspaper or read your fund's latest shareholder report. There, you will probably find returns that reflect the impact of annual fund expenses and, sometimes, fund sales commissions as well.
But figuring out how your individual stocks have fared is far trickier. Sure, we all remember the big winners. But what about the losers? What about dividends? What about the brokerage commissions and other trading costs we incurred? What about the extra risk we shouldered in buying individual stocks?
Unfortunately, most folks don't really know how their individual stocks have done, so they can't honestly judge whether they are better at picking stocks or picking funds.
TAXING MATTERS: If you own individual stocks, you have far greater control over your annual tax bill, because you can delay capital-gains taxes by postponing the sale of profitable positions. By contrast, most actively managed stock funds trade like crazy and, hence, generate big tax bills for their shareholders.
But that doesn't mean high tax bills are unavoidable for fund investors. You could stick these high-trading funds in your retirement account, while being much more selective about what you hold in your taxable account.
For instance, many fund companies have introduced tax-managed funds, which aim to keep taxable distributions to a minimum and, thus, are a good choice for taxable accounts. Also consider index funds. These funds simply buy and hold the stocks that constitute a market index in an effort to match the index's performance, so they tend to be tax-friendly.
ANYTHING BUT AVERAGE: The typical stock fund is a fine choice for investors, despite its tax inefficiency, high cost and indifferent performance.
But then again, who says you have to buy the typical fund? It is so easy to do better. It takes no great effort to stick with funds that are no-load and low cost, preferably with annual expenses below 1 percent. And it is simple to arrange your finances so that you keep tax-inefficient funds in your retirement account.
What about the lackluster results? That problem, too, is easily addressed. If you want to ensure that you get results that at least correspond to the market averages, all you have to do is buy index funds.
_ Jonathan Clements writes for the Wall Street Journal.