The Perils of Investing in Mutual Funds - TheStreet

It's a generally accepted axiom of investing that mutual funds are a prudent place for investors to entrust their capital. But as my readers already know, I cast a jaundiced eye at anything "generally accepted." While I'm going to pan mutual funds in this column, let me be clear:

I am not against mutual fund investing.

I think funds are an appropriate investment vehicle for many investors.

Don't MissIan McDonald's rebuttal to this article
Don't Give Up on Mutual Funds

But I also believe that a large percentage of investors are overinvested in mutual funds. They could do better on their own with an account at a discount broker and with help from us at

RealMoney.com

and other sources of quality information. Here are my top-10 reasons why I would not invest in equity mutual funds:

    The oops! factor. All money managers know when they have blown it. But making a mistake ( oops!) and getting out of the mistake are two different things. Sometimes positions are so large at major mutual funds that it can take days, weeks, even a month or two to work out of a position. As an individual investor, when you pull an "oops," you can dump the position the same day, maybe even in a few minutes. Yesterday's story. I don't want to buy into a pool of funds where some of the stocks are richly priced and have already rallied. When I invest new money, I want to buy today's best ideas based on today's prices, not yesterday's story. Flow of funds. Mutual fund managers have to adjust portfolios constantly based on inflows and outflows. If you are a shareholder in a successful mutual fund, there will be strong inflows of new funds. The managers won't complain (at least not publicly) because they are in business to attract capital. But unless the managers continue to buy the same stocks, at higher prices than when you bought in, your shares will be diluted. And outflows can wreak havoc on the mutual fund shareholder as well. Outflows require selling to meet redemptions. Selling part of the fund will depress the prices of the stocks in the fund, causing the fund value to decline for the remaining shareholders. Too many positions. Research shows that you don't need 150 positions to be diversified. Personally, I don't want to buy into a manager's 145th best idea. Give me your top 10 or 20 ideas -- the companies you have a passion about, not the afterthoughts that linger in the recesses of a large portfolio. Also, a money manager can't possibly know 100 or 150 companies in great detail. The less you know about a company, the greater the likelihood of mistakes. Poor performance. Maybe you won't do any better on your own than your mutual fund. But the performance hurdle is not high. If you are mediocre on your own, at least you will mirror, in the aggregate, the performance of mutual funds. Tax efficiency. Mutual funds are inefficient when it comes to taxes. Investors in mutual funds are often buying into an asset pool with large unrealized tax gains. If you manage your own account, it's much easier to keep an eye on tax liability. Personal preferences. I am uncomfortable investing in companies that produce tobacco products. I understand and accept other money managers who invest in any company, regardless of the industry. Besides a handful of mutual funds that have limiting criteria, the money invested in your mutual fund may be in companies you would be uncomfortable owning. Management issues. The sharpest minds, in general, don't manage mutual funds. Hold the nasty emails! There are many exceptions to this rule: Bill Nygren, Bob Olstein and Marty Whitman are favorites of mine. I am clearly biased on this issue, but, in general, I have been much more impressed with private money managers than mutual fund managers. Too-high costs. Virtually any mutual fund costs substantially more than a self-administered account at Ameritrade or E*Trade. Position-building. While you can build a position in a minute or two via an online discount broker, it can take mutual fund managers many days or weeks to build a position. And as they pour millions into a position, the stock reacts by going up, causing their average cost basis to rise. It's less efficient than if you, as an individual investor, bought the stock yourself. And when the managers of a mutual fund need to sell a large position, it generally takes time and causes the stock to decline. Again, the individual investor has a distinct advantage in being able to execute the trade almost instantly.

Note: While I believe investors are generally overinvested in equity mutual funds, I highly recommend funds if you are investing in corporate bonds, utilities and international stocks and bonds.

My Favorite Book

I never tire of reading anything and everything about

Warren Buffett

. I know there are many books about Buffett, and much of the information is filtered and interpreted. I don't care. I read it anyway.

Just out is the newly revised edition of

The Essays of Warren Buffett: Lessons for Corporate America

by Lawrence A. Cunningham. This is flat-out the best investment book I have read, a true must-read for all serious value investors. Let academia continue to ponder useless nonsense like the efficient market theory and random markets. Here is real-world investment wisdom that is useful for the individual investor.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment adviser specializing in turnaround situations. At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to

arnealsin@home.com.

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