As a former mutual fund portfolio manager for 20 years, I know a few things about how the industry works. It is a great industry—for people that work in the industry, that is. For investors, it’s not so good. Sure, mutual funds offer some advantages, such as ‘professional’ management and diversification. However, there are plenty of bad things about the mutual fund industry, as well, things that work to potentially severely hurt fund investors. No one, of course, ever talks about the bad side of the industry, as it is just too profitable for those employed by the investment industry money machine. But, since I don’t work in the industry anymore, here goes:

(1) Fees. How to best put this? Well, how about this analogy: Suppose you had a son, who was a ‘slightly above average’ hockey player. Would you encourage him to drop out of school, go out and buy an Audi R8 Spyder and wait for the NHL money to roll in? Of course you wouldn’t. But in the mutual fund world, if you are a consistent “slightly above average” mutual fund manager, then, well, you are an absolute superstar. Because of fees, so few managers can actually beat the market over any long period of time. The few that can become the Gretzky’s of the investment business, even if their funds are only slightly better than the market’s return. 95% of mutual funds managers simply cannot beat the index over the long term, because of fees. Especially these days, paying 2.5% in annual management fees when expected returns are just 5% or 6% is ridiculous. Why should a manager make half of the returns that you do, considering he/she won’t even beat the market? It simply makes no sense at all. Investors are far better off doing it themselves, or investing in an ETF instead.

(2) Short-term focus. This is a big problem in the investment industry overall. Mutual funds report portfolio returns on an annual basis, and clients hone in on one-year returns. Thus, if a manager if having a bad year, he or she will often change strategy in the middle of the year, in order to ‘save’ their yearly performance. This one-year focus prevents managers from thinking long term, and adds extra transaction costs. One reason Warren Buffett is so successful is that he truly thinks long term. Mutual fund managers, on the other hand, are often actively encouraged not to.

(3) Bonuses encourage gambling. The investment industry pays very well indeed, but a majority of compensation to managers is in the form of bonuses. Thus, managers are highly incentivized to ‘gamble’ if their fund performance is bad. Having a bad year? Well, to save your large bonus as a manager you simply have to take more risks with your fund. If the gamble works—big bonus time! And, similar to point #2, bonuses are tied to annual performance, so even more gambling with investment funds is often done. Very, very few mutual fund companies have bonuses that are based on long-term investment performance.

(4) Asset gathering overrules fundamentals. As a fund manager, your priority is to bring in money. When fund managers are speaking to potential investors, keep in mind that they really are trying to bring more money into their fund. Thus, most managers will never say anything bad about the stock market. Even if the market is plunging, and there is a giant recession looming, a manager’s goal is to keep investors calm and, get more money in the door. Thus, a manager is discouraged from telling the ‘truth’ about how they feel. If a portfolio manager ever said, ‘hey, don’t buy my fund, the market is going down”, they would likely get severely admonished by their boss. It is all about marketing, and sometimes, the truth is stretched wildly to bring in more money.

So, next time you see some slick mutual fund marketing or commercial, remember these negatives. There are lots more, too, which we will get to in another article.