Almost all of them would be better off just holding a diversified index fund, rather than a high-fee, actively managed fund that brags about performance one year and hides its face the next. That fund volatility is a problem for a lot of reasons, and the main one is churn. Investors tend to chase performance, when they should just buy and hold.
By buying and selling frequently, they pay put themselves on the hook for a lot of transaction fees, which undermines returns.
To use one example, Morningstar reported that technology funds generated actual returns more than 13 percent below their reported results. Actual returns are what investors get because they tend to buy when prices are high and sell when they're low. Reported results assume much better behavior, and give the wrong impression.
Morningstar ranks mutual funds, giving them ratings of one to five stars, which typically reflect their recent performance. Five stars mean a fund has been doing well, while one is a sign of poor returns. Every year, a few funds get lucky and a few others fall from favor, and investors chase stars like they were real money.
But the only true signal of a fund's quality has nothing to do with stars, and everything to do with how much money they want you to pay to invest. The price tag on mutual funds is called an expense ratio, which is the share of your assets you pay the fund for the privilege of having them invest your money.
"If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds," according to Russel Kinnel, a director of research at Morningstar. "Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.
So what's Kinnel saying? He's saying that the less you pay, the more you get. That's the topsy-turvy world of mutual funds. High price is not a sign of quality here, it's the sign that you're getting ripped off.
Mutual funds manage to pack a lot of different kinds of fees into their expense ratios, which average more than 1 percent of assets, and can climb higher than 3 percent. Let's break them down here:
These are the fees you pay to the gurus who choose the right stocks to include in an actively managed fund. While it sounds like a great idea, it turns out that most professionals are really bad at beating the market average, which means you're paying for below-average returns. An index fund would serve you better.
This is the fund's additional overhead: postage, keeping records, client service and the office coffee machine.
This fee goes towards marketing. Funds pay to promote and advertise themselves, and also pay broker commissions. Maybe that's how you heard about yours in the first place. The irony, of course, is that the funds pay to brag about their performance, and to the extent they do, they diminish their investors' returns. (The SEC announced in 2013 that it would investigate funds and advisers for potential conflicts of interest tied to these distribution fees.)
Finally, mutual funds have a transaction fee that isn't part of the expense ratio. It's called a "load," and it can be very heavy. There are several kinds.
Front-end loads are the fee you pay to an adviser or broker for their supposed expertise in choosing the fund for you. A 5% fee means the $10,000 you want to invest decreases by $500 before it ever hits your account. That's a deep hole to crawl out of to break even.
Back-end loads are more complicated, because you pay when you sell the fund, and they change over time. If you sell right away, you pay a higher load of, say, 6%, while if you stay in the fund for seven years (during which you pay their expense ratio), they'll waive the fee altogether. How nice of them!
If you don't like the sound of loads, just put your money into a low-fee index fund. You cut out the underperforming gurus, the conflicts of interest, the advertisements and the commissions, and that leaves you with a lot more money in the end.
Bill Sharpe, who won a Nobel Prize for his work on investment theory, estimates that investors could increase their returns by more than 20 percent just by avoiding high-fee funds like this (Read more).
FutureAdvisor can show you whether you've got the right kind of funds in your portfolio. Try our free analysis now.