The Taylor Frigon Advisor: Some drawbacks of mutual funds

We've written in numerous previous posts about our conviction that "ownership of successful business enterprises which continued to grow and prosper over a long period of years" should form the bedrock foundation of capital investments for most investors. While there are many other important investment strategies which should be added in certain situations (such as a strategy which will yield current income, or a strategy which gains exposure to earlier-stage enterprises), these should still be built upon the foundation of the ownership of successful business enterprises.

We have also shared some information about obstacles investors face even if they understand and agree with this philosophy. Principal among these obstacles is the intermediary system of "wealth management" that has developed over the past few decades, which separates investors from those who actually evaluate and select those individual businesses (see, for example, this previous post).

However, there is another major obstacle to the investor's ability to build a foundation on the ownership of successful businesses over a long period of years, one that is so widespread and so basic to the modern investment landscape that most investors would be shocked to learn that it has such drawbacks: the mutual fund.

In 1980 there were about $135 billion in assets in all the mutual fund investments in the United States -- today there are more than $11.7 trillion (ICI). Mutual funds are very scalable, and with the proliferation of intermediary "wealth managers" and "financial advisors" who do not actually manage money but instead "outsource" the management to others, the assets committed to mutual funds grew significantly.

But the mutual fund model has many drawbacks, some of which are not fully understood even by very wealthy investors.

One drawback is that the individual investor no longer owns the securities (such as the shares of common stock) in his own account, but rather owns shares of the mutual fund, as depicted in the diagram above. An open-ended investment company (the more precise term for a mutual fund) is a pooled vehicle, in which the assets of the investors are pooled, and the pool owns the shares rather than the individual investor, who owns shares in the pool instead. This serves to distance the investor from the ownership, and brings about a variety of other side-effects which impede the investor's ability to build a foundation of ownership for "a long period of years."

One significant negative side-effect is the tax drawbacks to the mutual fund's pooled ownership structure. We discuss some details of this tax drawback in a commentary we published called "Separate Portfolio Advantages" which is available on-line. The tax drawbacks to mutual funds can be extremely damaging to wealthier investors, who are typically taxed at higher rates and have more exposure to a wider variety of taxes.

Another significant drawback to mutual funds is that they tend in many cases to rely upon an investment process that is based on the performance of markets rather than the performance of businesses, which is a crucial distinction. The reason for this tendency is again related to their pooled nature and to their size, as we detailed in this previous post. Basing your financial future on an ability to call the next move in a market (or, in the case of many mutual funds, of one sector of the market versus another sector of the market) is in many ways the opposite of basing your financial future on ownership of successful businesses for a long period of years.

We have also discussed the problems of "style drift" and "deworsification," both of which are also obstacles to the investor and both of which are tendencies that the mutual fund structure can exhibit, especially as a mutual fund's pool of assets becomes larger and larger.

In short, although there are mutual funds which are the exception to the rule and there certainly is a place for them with investors who are too small to adequately own individual companies outright, there are significant drawbacks associated with mutual funds. Many investors are not aware of these, although they should be in light of the popularity of mutual funds as an investment vehicle. Most importantly from our perspective are the ways in which these drawbacks tend to inhibit the average investor from pursuing what we know to be a successful formula for the creation of long-term wealth: "the ownership of successful business enterprises [. . .] over a long period of years."

For later posts dealing with this same subject, see also: