Disadvantages of Mutual Fund Investments - How Fund Managers Struggle to Beat the Market

Right before I decided to invest in stocks, a couple of months ago, I made a search for a book I can read to learn something about stock investing. I thought it would save me a lot of trouble to learn how to pick the right stocks to invest in.

Luckily, I came across this amazing book by Benjamin Graham called The Intelligent Investor. This book is a classic! It was published in 1973 and yet it still contains the basic knowledge everyone should know about stocks. (If you want a copy, it’s being sold at National Bookstore).

Benjamin Graham was a mentor to one of the most successful business person who built his wealth through stocks - Warren Buffett. There’s a high likelihood that you know who Warren Buffett is if you have any interest in investing.

There’s no other book about stocks that Warren would recommend other than The Intelligent Investor (and Security Analysis) written by his mentor Benjamin Graham.

The book is extremely informative. The insights it provides, I believe, are critically important for anyone who is serious about investing in stocks.

Moreover, the updated edition contains invaluable commentary by Jason Zweig. These commentaries have been helpful to me to further understand the concepts Mr. Graham was trying to convey.

Discussions on Mutual Funds

It is among these commentaries that I gained some understanding about mutual funds. Among Filipino investors, mutual funds are fast-becoming a very popular investment choice. They present an opportunity to participate in a diversified portfolio with a relatively small capital.

It’s been said that if you do not have any investing skill at all, you should go for mutual funds. You wouldn’t have to worry about your investments because with mutual funds, someone will manage it for you.

Professional Fund Managers

Mutual funds are managed by professional investors. They are known as fund managers. Unlike most people, these fund managers have the necessary skills and experience for sound investing.

But according to Jason Zweig, fund managers are saddled with handicaps. These handicaps are the reasons why they may find it difficult to maximize investment returns.

Sound investing strategies can be difficult to follow if you’re a fund manager. Often times, their investment portfolio moves in accordance with the market whether they like it or not.

As much as they hate it, fund managers can’t help but buy when the market is high and sell when the market is low.

Here are some of the reasons for that as stated in the book. I quote verbatim because I do not believe I can provide a better explanation. Jason Zweig wrote:
  • With billions of dollars under management, they (fund managers) must gravitate toward the biggest stocks-the only ones they can buy in the multimillion-dollar quantities they need to fill their portfolios. Thus many funds end up owning the same few overpriced giants.
  • Investors tend to pour more money into funds as the market rises. The managers use that new cash to buy more of the stocks they already own, driving prices to even more dangerous heights.
  • If fund investors ask for their money back when the market drops, the managers may need to sell stocks to cash them out. Just as the funds are forced to buy stocks at inflated prices in a rising market, they become forced sellers as stocks get cheap again.
  • Many portfolio managers get bonuses for beating the market, so they obsessively measure their returns against benchmarks like the S & P 500 index. If a company gets added to an index, hundreds of funds compulsively buy it. (If they don't, and that stock then does well, the managers look foolish; on the other hand, if they buy it and it does poorly, no one will blame them.)

Should You Still Invest in Mutual Funds?

Knowing that these handicaps exist should help a mutual fund investor appreciate the difficult job of his or her fund manager. But it also highlights the weaknesses of mutual funds which may make you think twice before you invest.

If you had the skill and knowledge to build your own portfolio, you may just be better off managing your own fund. This will free you from the obvious investing mistakes fund managers are forced to make.

But doing it your own will also present risks that can be far more devastating if you don’t know what you’re doing. So in the end, the decision to invest or not in mutual funds will depend on your willingness to spend time to learn.

If you think it’s not worth your time to study investing, you invariably pay the price when going for mutual funds. Management fees and fund managers’ investing handicaps will have negative impacts to your investment.

For most people, this is a price they are willing to pay. I don’t blame them knowing how difficult it can be to learn stock investing much less do it yourself without professional help.

Photo Credit: 401(K) 2012 (Creative Commons)