Tax inefficiency

Another disadvantage to mutual funds is that stock funds (also called equity funds) are not very “tax-efficient.” Here’s how this inefficiency plays out in your overall investment picture:

When you own individual stocks, you decide when to buy and sell them.
When you sell a stock that has increased in price, you receive a type of profit known as a capital gain. At the end of the year, you must pay taxes to the IRS on all the capital gains you enjoyed during that year. But with mutual funds, the schedule of stock purchases and sales is up to the fund manager —you don’t have control of the timing.

Fortunately, there are funds managed specifically to minimize tax inefficiency. I explain how this works in Chapter 9. Many stock investors carefully regulate their sales of stock so that they incur capital gains when the additional money is less burdensome to their tax situation. For example, a stock investor might choose to realize her capital gains during a year when her salary from work is smaller, thereby reducing her overall tax rate.
Mutual fund investing, however, means that you may receive capital gains distributions from the fund at any time. Of course, you end up paying taxes on these at the end of the year. At tax time, mutual fund firms send out copies of Tax Form 1099-DIV to their mutual fund investors. The document details taxable earnings. Don’t fail to report this income on your return; the fund company is also reporting it to the IRS, which will check for discrepancies.

If you are in a high tax bracket — that is, if your overall income is large enough to make your federal tax rate burdensome — and if you have a significant amount of money to invest in the stock market (say, $25,000 or more), you may want to consider investing in individual stocks rather than mutual funds so that you can better control the tax effects of your investments.

Lack of insurance for fund investments

Unlike your deposit in a bank, credit union, or savings and loan association (S&L), your investment in a mutual fund is not insured by the Federal Deposit Insurance Corporation or any other government agency. (Supervision of investment companies by the Security Exchange Commission and other organizations does not insure the value of your investment.) Therefore, when the fund invests in securities that rise and fall in value, you have the possibility of losing your initial investment.
In some states, mutual funds may be sold by banks and S&Ls or by brokerage companies associated with them and housed on the same premises. Read the fine print, and don’t be confused. Although you may make a mutual fund investment over a counter in your local bank, your money will not be insured the way a bank deposit is. Walk, don’t run, from any banker who implies the opposite.

Unclear investment approach

Sometimes funds are managed in ways that contradict the image presented in advertising or promotion. A fund that is touted as a conservative fund — one that selects investments so as to minimize risk and volatility — may be managed in an aggressive manner, putting money into highly volatile small-company stocks, for example.
A fund that calls itself a stock fund may actually keep a sizeable portion of its investment money in cash or in short-term government bonds, which are considered equivalent to cash; thus, it may miss out on some of the gains enjoyed during a strong period for the stock market.
Instead of relying solely on advertising, press accounts, or the advice of a broker, always ask for a prospectus before investing in a fund. This is a detailed description of the fund and its investments, written according to government guidelines. Compare what you read in the prospectus with the sales pitch presented in ads or by a broker. If you feel there’s a contradiction between them, don’t hesitate to ask about it.

Risk involving changes in the market

Even with expert management, however, the risk involved in mutual fund investing does not disappear. Sometimes, the stock or bond market as a whole may be in decline, and even smart investors are unable to make a profit. Such hard times are referred to as bear markets.
The opposite of a bear market is a time when the markets are steadily rising — bull market. Pessimistic investors are sometimes referred to as bears, while optimists are bulls. Now you understand the livestock references that you often hear scattered throughout financial news reports!
If you’re a long-term investor, bear markets may not be a problem. You can probably wait until the market rebounds before selling your shares. A short-term investor, however, may get stuck with losses. Although you can’t avoid risk altogether, you can choose money market mutual funds or other investments that don’t tend to fluctuate dramatically.

Risks involving fund management

These days, mutual funds are among your safer investment options. Diversification, professional management, and the fraud-prevention exercised by the Security Exchange Commission and other regulatory bodies all help ensure that mutual funds stay relatively safe. Nonetheless, investing in mutual funds carries various kinds of risk that can impact your financial planning.

One risk that’s inherent in the nature of mutual funds is the fact that you, the investor, have no control over what’s being purchased for the portfolio. You are putting your money —and your investment fate — in the hands of the fund manager, which is why you need to study the track record of the fund company and the individual manager before you invest. Making sure that you’re giving your money to a reliable partner is important to your pocketbook and your peace of mind.

Another unpredictable challenge may arise when a fund’s “star” manager retires or changes jobs, leaving the fund without his expertise or brilliance. For example, Peter Lynch was one of the most successful and famous mutual fund managers in the world for many years. Under his guidance, the Fidelity Magellan Fund grew into the largest mutual fund anywhere, with over $72 billion in assets. Millions of investors poured money into Magellan, attracted largely by Lynch’s reputation and prestige. Since Lynch’s retirement in 1990, however, Magellan has performed with far less success, despite the strong performance of the stock market overall. If you’re a fund investor, follow the financial news. Be aware when changes in the management of your funds occur. You may want to consider switching funds when the manager responsible for your fund’s track record departs the scene.

Shareholder services of Mutual Funds

Many mutual fund companies offer a range of useful, sometimes valuable services to their customers. These may include

• Check-writing privileges
• Ability to invest, withdraw, or move money via mail, telephone, or the Internet
• Automatic investment via payroll deduction
• Record-keeping for filing your income tax return
• Access to research reports about companies, funds, and economic trends

A fund’s prospectus tells you more about such services.

Liquidity of Mutual Funds

Liquidity refers to the ease with which you can buy or sell an investment. Buying or selling a particular stock or bond, especially one held by relatively few people, may be difficult. If you need cash in an emergency, this obstacle to turning your investment into legal tender can cause inconvenience and may cost you money. By contrast, mutual fund shares can be cashed in quickly at any time by redeeming them with the managing company, usually at little or no cost.