Mutual Fund Faceoff: Now More Than Ever, It's Time to Steer Clear of Funds

In the aggregate, mutual funds don't add much to society.

So if investors withdrew their funds en masse from all mutual funds, society would benefit from the amount of the fees and costs currently enriching mutual fund companies. And the performance of investors -- again, in the aggregate -- would improve by the amount of saved fees.

But we know investors aren't going to forgo the security blanket of mutual fund investing any time soon. Funds will continue operating in the same vein tomorrow as yesterday, generating huge fees while generating abysmal below-market returns.

Readers of this column should, at a minimum, critically evaluate their commitment to mutual funds. I've written before on the perils of investing in mutual funds, and Ian has responded with his own arguments.

Here are several reasons why I think many investors will particularly suffer from overexposure to equity mutual funds in the next few years.

It's a New Cycle, Baby!

Investors need to be able to identify the excess of a prior cycle in order to be better positioned for a new cycle. The old cycle was marked by excess in tech, telecom and big-cap stocks.

The new cycle, which I think started in December, is very different. It's about small- and mid-caps, and value over growth. Smart stock pickers have a tremendous advantage over market indices and mutual funds in this environment. And the evidence is stark: Since December, the average stock has increased in value, while all the major indices are down, and so are the vast majority of mutual funds.

Index Funds Are Not the Answer

So if I'm right, even index mutual funds will not be a lot of help to investors. With big-cap values stretched, compared with smaller stocks, most index funds will not perform as well as the average stock. That's because almost every index is market-weighted, so index fund performance will be disproportionately affected by big-cap stocks.

Funds Are Part of the Problem

Funds are always a step behind. When the market rallied in the last cycle on the back of fewer and fewer names -- all of which were big-cap -- mutual funds exacerbated the problem, aggressively playing catch-up and bidding up the valuations of the big names to unsustainable heights.

Now that the cycle of big-cap growth and technology is over, funds are again behind the curve, as they are gradually getting positioned in mid-cap and small-cap value stocks. Individual investors can do better -- and they should know better -- than contribute to the largess of the fund industry when they get nothing in return.