NEW YORK (CNN/Money) -
I'm on vacation this week, so I'll be sending out two columns on a subject that is crucial for individual investors. Tuesday's column discusses the serious problems affecting the mutual fund industry over the past few years. Thursday's column will focus on specific strategies that will help you use mutual funds to your greatest advantage.
Mutual funds enjoyed an unprecedented expansion as the stock market soared in the 1990s. Assets in equity funds shot up from $239 billion in 1990 to a staggering $4 trillion in 1999. And annual equity fund inflows rocketed from $13 billion in 1990 to $309 billion in 2000.
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The bear market changed that. Investors actually withdrew money from equity funds in 2002, the last full year before the recovery began. Since then, money has been flowing back into equity funds, but there are signs that investors are still anxious, particularly because of the fund scandals that have damaged investor confidence in the entire industry.
A recent poll done for the National Association of Investors Corporation -- an organization that promotes investment clubs -- found that 40 percent of fund shareholders are quite concerned. And more than 10 percent say they actually sold fund shares because of scandals.
Usually, though, improper fund practices are not the biggest risks investors face. The cost to shareholders of overly high fund management expenses and unnecessary trading costs are roughly five times as great as the estimated cost of all the recent improper fund practices.
In short, the real scandal is not what's improper, but what's legal -- and what's common industry practice.
Of course, there are many situations in which mutual funds are the best available investments. People who want to build portfolios slowly with regular contributions can do well with funds, as can people with less than $50,000 to invest.
Funds are also the best ways to invest in certain market niches -- gold-mining shares, for instance. And they also work well for assets that are difficult to assess, such as certain foreign stocks or obscure convertible bonds.
But there are several basic problems funds can't entirely escape. Managers have to compete with each other, which pushes them to over-invest at market peaks and hesitate to commit when stocks are depressed.
Many managers remain nearly fully invested, even when large holdings of cash might be a wiser choice. And scandals do occur. So does poor judgment about portfolio choices.
The biggest negative, though, is simply the cost of fund fees. Except in the case of index funds, expenses severely cut into your returns.
In Thursday's column, I'll discuss when investors should consider mutual funds and outline the smart strategies for avoiding unnecessary fees, minimizing you risk and earning the best long-term returns.
Michael Sivy is an editor-at-large for MONEY magazine. Sign up for free e-mail delivery every Tuesday and Thursday of Sivy on Stocks.
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