Frequently I am asked about my opinion on the value of mutual funds. Since the early 1980’s their popularity has grown exponentially where many investors feel they are simply the only choice available. However by and large they have many disadvantages that are frequently rarely discussed:

Taxation: Taxation for mutual funds is arcane to say the least. Beware of buying a mutual fund in a taxable account in late summer through October until after it declares Capital Gains. For instance, you may buy a fund in a taxable account in June but you need to understand you’ll be liable for taxes generated by the fund for the entire year up to and including from the date of purchase. If the fund should drop in value, beware you may still be liable for capital gains taxes despite your loss.

Lack of a defensive strategy: equity funds rely primarily on a “buy and hold” strategy that is most effective when the stock market is in a secular bull market. This has not been the case since 1999. Since most funds stay fully invested at all times, the chance of reaping gains in a choppy environment is difficult unless you the investor possesses a strategy to sell the fund when risk is high.

Lack of input: This issue is of primary concern to Socially Responsible and Green Investors. Many SRI funds screen for as many as 15 social issues and will include a stock in its portfolio if is considered ‘best of the lot”. This issue was brought to the forefront during the Gulf Oil Spill when many SRI funds owned shares of BP, which at the time was considered best of the integrated oil companies.

Relatively few stellar performers: Most equity funds do not exceed the return of their corresponding benchmark indices which is why Indexing has a place for many investors. As funds grow in size their performance tends to be diluted as assets grow.
Specialized mutual funds: Bond funds, especially funds related to High Yield, Inflation Indexed Bonds and Convertibles are frequently either very expensive or difficult to buy individually on the open market. Hence using a mutual fund for this asset allocation tends to make a great deal of sense.

Closed Ended Funds: These are mutual funds whose shares trade on the open market. During periods of high market stress when sellers sell simply for the sake of it, many fund values will drop below their Net Asset Value. Buying closed end funds selling below NAV is frequently a very profitable and effective strategy as long as the underlying assets of the fund don’t continue to drop below your purchase price.

In sum, while its difficult to paint all mutual funds with the same brush, many funds deserve their market share and desire to be owned. However, its our opinion that the mass marketing by the mutual fund industry frequently enforces a belief that mutual funds are the only and primary answer for investors, which is not the case.

About the Author:

Brad Pappas is portfolio manager and principal of Rocky Mountain Humane Investing.

RMHI is a private portfolio management firm located near Boulder, Colorado.

You can find his website at and blog at

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