By Alvin Chow (guest contributor)
Be careful when agents try to sell you mutual funds (equivalent to unit trusts in Singapore). Since you do not have the expertise and time, you may feel it is better to leave your money with the professional fund managers. It seems like the easy way out, but there are important issues that you need to understand before you decide.
1. Most actively managed funds cannot beat the benchmark or the index over the long run
John Bogle, the founder of Vanguard funds and a strong supporter of index funds, analysed the performance of US mutual funds in the 36-year period from 1970-2006. At the start of 1970 there were 355 equity funds. By 2006, only three out of the original 355 funds beat the index consistently over the 36-year period.
Hence, your chances of picking the three winners are a slim 0.8 percent. You can improve your chances by investing in the index fund instead.
2. High fund management fees eats into your earnings
One of the reasons why it is so difficult for funds to beat the index is because the annual management fees (typically two to three percent) reduce your returns. Moreover, the fees are fixed no matter how the fund performs – even if the fund had a negative return, the manager still gets paid. Over time, compound interest can aid you. But your annual fund management fees can compound against you as well.
3. Randomness of the market
Burton Malkiel (author of A Random Walk Down Wall Street) and many other efficient market believers feel that you cannot predict the market and profit from it. Fund managers cannot disprove the luck factor in their success or failure.
Nassim Taleb further addressed the randomness in his book, Fooled by Randomness. He mentioned that randomness very much determines the success or failure of managers. To answer how some managers managed to be spot on in stocks, he drew the analogy of coin-throwing where everyone has a 50-50 chance of the correct answer. For example, we begin with 100 managers, after one throw, 50 managers were right. After second throw, 25…third, 12… fourth, 6, after the fifth throw, 3.
This is a simplified explanation of how the top three funds can be spot on for five years in a row. But how long can they sustain their luck?
4. Restrictions for fund managers
Fund managers are restricted by the description of their respective funds. Even if a golden opportunity comes knocking, they may not be able to seize it. If a particular sector or country is undergoing a downturn, they may have to stay invested as stated in their fund objectives.
An additional problem also arises when the fund gets too big. They may be pressured to keep the money invested, even when there are no good options. In the end, they may end up with second-rate investments. The restrictions and pressures piled on top of the randomness effect make it even more difficult for managers to beat the market.
5. Sales charges
Like management fees, sales charges (when you buy and sell) eat your earnings. It is true that there are a few funds that can beat the market each year.
But it is also often the case that this year’s top five funds will not be the next year’s top five. The chances of finding the top performing ones are slim. Buying and selling frequently will also incur a lot of sales charges, which greatly reduces your returns even if you managed to pick one or two correct ones.
If someone tries to sell you mutual funds, pose these arguments to them. If they can defend their products convincingly, they deserve to be considered.
By guest contributor Alvin Chow, who blogs at Big Fat Purse, a Singapore personal finance blog. Posted via www.MoneyMatters.sg, your guide on how to make more money, save smarter, invest intelligently, and enjoy your money like a pro. Click here to get our free report on what you must know about financial freedom.