by Billy Funderburk, CFP®, MBA
When deciding on tools for building your portfolio, most people just assume that mutual funds are the best tool. That’s probably true when you are getting started and need to diversify your portfolio but don’t have enough money to buy a minimum number of stocks to achieve this. However, once your portfolio gets large enough, there can be distinct advantages to buying stock in companies themselves.
Five Disadvantages of Mutual Funds:
Fees – According to Morningstar, the average expense ratio of an actively managed mutual fund is 0.72% (Morningstar, 12/31/2017). When owning stocks, your only significant expense will be the cost of the transaction to purchase and/or sell the stock. Mutual funds also are subject to transaction fees, so the main difference in expenses between the two investments is the mutual fund expense ratio. At the “starting line” you are this much ahead on your returns when owning stocks.
Tax Inefficiency – If you have owned mutual funds in the past, you have perhaps noticed that you received a tax document at the end of the year informing you that you owe capital gains taxes. When selling stocks at a profit, mutual funds are subject to paying capital gains taxes on profits just like you are when you sell your stocks. The difference is that you have control over this when you own stocks. With mutual funds, you are held hostage to the fund manager’s decisions.
Over Diversification – According to Terry Smith of the Financial Times, the average equity mutual fund managers own 90 stocks (Financial Times, April 12, 2013). However, 95% of the benefits of diversification can be obtained by owning just 30 stocks (Larry Swedroe, “Portfolio Diversification: How many stocks are enough? Mutual Funds.com, 2-17-2015). Do you really know 90 stocks that you feel good enough about to own? In our opinion, by narrowing your list down to 30 stocks, you could have a better chance of choosing winners.
Personalization – When you own a mutual fund, you have no control over the composition of the portfolio. Sure, the fund you own may have a methodology that you agree with, but if you want to own stocks that you feel good about, you need to own them directly. In this way, the portfolio can be tailored specifically to your needs.
Excess Cash – Of the 100 largest mutual funds, the average cash position was 9% and the median cash position was 5.8% (Morningstar, 2017). Mutual funds keep cash positions for several reason, the primary one being a need to have cash for client withdrawals. If they did not do this, they would be forced to sell stocks at times based on the whims of their clients. Want to take a guess what the average return on that cash was? This practice can be a significant drag on the returns of mutual funds.
At Funderburk Financial, we adhere to this investment philosophy with our clients when appropriate. Let us show you how owning individual stocks can work for you.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
Stock investing involves risk including loss of principal.