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Mutual funds may not be your best option 

Tuesday, October 13th, 2015

Over my 32 years in the investment field, there have been many changes. But one thing that has stayed somewhat the same is the concept of mutual funds.

You may have a basic understanding of mutual funds- that your money is pooled with the other investor’s money, and at the end of each day the values of all the holdings are totaled and divided by the shares outstanding.

With open ended mutual funds, they can continually issue new shares as more money comes in.

 As a whole mutual funds have done pretty well, but they have not been as good as money managers like myself who actually buy individual securities for their clients and keep them separate from other clients.

 I have explained this for many years, but with the recent pull back in the stock market in August and then the rebound come early October, now I can demonstrate why mutual funds may not be your best option.

 First off, let me reveal to you the performance of a couple of mutual funds versus the index. Then I will explain why the mutual funds don't perform as well as the indexes or an individualized concentrated value portfolio.

Let me give you the return numbers for the Dow Jones’ industrial average, which is close to a concentrated portfolio with 30 holdings. On August 25, 2015, the Dow Jones’ industrial average hit a low of 15,666.44.

Since that timeframe, using October 6, 2015 as the ending period, The Dow Jones recovered back to 16,790.19 (an investment return of 7.17 %.)

For comparison purposes I looked at four well-known mutual funds that have good long-term track records. I compared their return over the same timeframe of August 25, 2015 to October 6 of 2015.

 The Fidelity Contrafund gained only 5.2% over that timeframe and has cash of 2.6%. That was the best of the four that I looked at. The Fidelity Magellan Fund, which has 1.1% in cash, only gained 4.8% for the comparison timeframe.

 A popular fund group is Vanguard, which manages the Windsor fund, a well-known and popular fund. Their cash balance was also low at 1.8% and the return over the comparison timeframe was 4.6%.

 The worst performer of the funds that I looked at was another popular fund group called the American Funds. I looked at the Growth Fund of America, which was one when I was young and inexperienced and thought it was a very good fund.

 Don't get me wrong- you will make money with all of these funds, but as I became wiser I realized that mutual funds are not the smartest option; however it is the easiest option for the broker or advisor.

 Return for the Growth Fund of America was only 4.43% for the comparison timeframe, which is 38% lower than the return for the Dow Jones Industrial Average. This fund does hold the most cash of my comparison at 5.7%.

 So it is obvious to see that these four mutual funds did not gain what they lost compared to the Dow Jones industrial average.

 There are a couple of reasons why this happened, and will happen to holders of mutual funds many times over a long time horizon. It is because when the markets decline, it is due to people selling out of their stock investments. However if you are holder of a mutual fund, you sell shares of your mutual fund back to the mutual fund group and they send you cash.

 This is why I check the cash balance on the mutual funds- to see how much cash they were holding to meet redemptions. As you can see, their cash was not that high.

 This causes the problem to where the mutual fund manager must sell some stocks to meet the redemption requirements, and he has to sell those stocks at a lower price. The manager may also elect to sell more stock because he wants to keep the cash balance higher, or because he fears more future redemptions. 

 Either way it is not a win for the mutual fund investor. You as a shareholder may have not sold your shares, but if the fund manager sold shares of stock, technically you did as well.

 As an example, say a mutual fund had 1 million shares of the liquid bottle company, and to meet redemptions the manager had to sell 100,000 shares. The fund is only left with 900,000 shares, and therefore your holdings are not as good as they were before.

 Let's further say that the liquid bottle company was trading at $10 a share and had a decline in stock price of 10%, down to nine dollars a share. If the fund manager did not have to sell those shares, it would take a return of 11.1% to get back to the original $10 million value.

 But if that manager had to sell 100,000 shares to raise cash to pay out to shareholders, that 900,000 shares would only be worth $8.1 million. To get back to $10 million it would take a gain of roughly 23 1/2%.

 In simple terms, this is why the mutual funds won't come back as quickly as the indexes.

 Another problem is that the mutual fund manager cannot take advantage of buying more stocks at a lower price, because they had to send cash out to the mutual fund shareholders. The mutual fund shareholders are not as smart as the other shareholders who will stay invested and not sell their shares based on emotions.

 This can make a big difference for performance. The big reason why I created the individualized concentrated value portfolio concept years ago was so the smart investors could take advantage of the lower prices when stock prices fell and not be hurt by other investors cashing in their shares and using up cash that should be used to invest, not meet liquidation requirements.

 And as was explained just a few weeks ago in The Smart Investing Newsletter, ETF's don't provide much help in rapidly falling markets because investors can sell them very quickly, and the losses may not represent accurately the true value of the underlying securities at different periods of time.

So there is no doubt the best method of investing in stocks is to either: hold the individual securities yourself, while making sure that you are doing all the required research and not putting your emotions into your investment decisions, which I know is hard but is it absolute must; or if you can't do this yourself because of the time that it takes, or maybe the lack of desire, that is why my firm Wilsey Asset Management created the individualized concentrated value portfolio.


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