Are Mutual Funds Still Relevant?
A recent article in Financial Times caught my eye: The mutual fund at 100: is it becoming obsolete?
For 15 years, I worked for a public asset manager and spent the final few years as the Head of Product Management. Our biggest products were mutual funds. The question posed by the article’s author is one we asked ourselves on many occasions. Admittedly, given my background, I probably have more interest in the subject than many others.
Still, we receive variations of this question from clients regularly. I wanted to share how we think about this topic in our current role, as private wealth managers working with families and business owners.
I’ll start with my opinions first, then some additional context for those that are interested.
Mutual funds may still be the most appropriate investment vehicle for many investors. If you own mutual funds, no reason to panic.
Mutual funds may eventually become obsolete. But they’re still a very long way from being dead, especially those that charge reasonable fees, have sound and repeatable processes that have delivered impressive long-term results, and are managed by strong investment teams.
Investors earning high incomes, or those expecting to earn high incomes, may want to consider alternatives within taxable investments accounts.
What is the primary benefit of mutual funds?
Mutual funds allow investors a simple way to diversify. Investors pool their assets with other investors, and a mutual fund manager handles the buying and selling of individual securities on their behalf. They can be designed to mimic an index, like an S&P 500 index fund, or they can be managed by professional investors who attempt to outperform an index. There are other advantages, to be sure, but this is the biggest, in my opinion.
What is one of the drawbacks of mutual funds?
Mutual funds are required to distribute at least 90% of all income, dividends, and realized capital gains each year to shareholders to avoid double taxation.
The mutual fund shareholder will receive those distributions and pay any associated tax, even if they did not sell. I shared a personal story on this topic last year. Here’s the main point: owning mutual funds in taxable accounts can create unwanted tax. The owner of the mutual fund shares does not have much control over the timing of tax liabilities. If gains are realized by the fund that exceed realized losses, meaning the fund manager sold investments that had more gains than losses, those realized gains need to be passed on to the shareholders.
Those distributions will need to be reported to the IRS in the year they were received.
Not sure if this applies to you? Grab a copy of your consolidated 1099 and look at the section labeled 1099-DIV, specifically box 2a. Or, if you already filed your return, look at line 7 on the front page of your 1040. If you see a big number there and don’t recall selling investments in a taxable account last year, these distributions may have come from mutual funds.
But this piece of the internal revenue code doesn’t just impact mutual funds. It applies to all registered investment companies, or RICs. Exchange-traded funds, or ETFs, are not immune. An investment company, in a nutshell, is a company that issues securities and was created to invest in securities. Here is the explanation from the Securities and Exchange Commission (SEC).
What alternatives might make more sense?
Here are two options that could be worth consideration.
ETFs, as I just mentioned, are also RICs. But their structure generally gives investors more control over when taxes are due, and they often charge lower fees than mutual fund alternatives. The details are beyond the scope of this post, but please feel free to reach out if you are curious.
Another article from Financial Times reported active ETFs attracted over $100 billion in new assets last year, which accounted for 18% of all the net new assets invested in ETFs in 2023. That represents a significant jump from recent years. Index ETFs have been gaining popularity for quite some time, and now, as the article points out, actively-managed ETFs seem to be doing the same.
When choosing investment managers, fees are usually part of the equation. We looked at all actively-managed large cap U.S. ETFs in Morningstar’s database - 176 ETFs in total. Then we weighted the expense ratios by total assets, wanting to give more relevance to funds investors actually own. The weighted average expense ratio for these funds is 0.29%.
Source: Divvi Wealth Management, Morningstar Direct
How does that compare? We did the same for mutual funds, starting with the cheapest share classes reserved for institutional investors, fee-based accounts, and big retirement accounts like 401(k) plans. That left a whopping 1,279 options. And the weighted average expense ratio for these funds is 0.47%. U.S. large cap mutual funds with front loads (i.e. commissions, often class A shares) and no sales loads fared worse, with a weighted average expense ratio of 0.60%, more than double the cost of the ETF group. The chart summarizes these results.
We have tons of ETF options today. Morningstar’s U.S. database currently includes over 2,100 index-tracking ETFs - those that are designed to mimic an index - and almost 1,500 actively managed ETFs - these are generally trying to outperform an index. The FT.com article linked above speaks to the recent growth of active ETFs, and we think there’s good reason investors find these options appealing.
Direct indexing is also on the rise. These strategies start with a familiar concept - indexing. Mimic the returns of an index as closely as possible. And then it often attempts to improve upon those returns by adding a tax benefit, through tax loss harvesting.
Losses can be used to offset realized gains at tax time. Here is a video I recorded last year, covering this in more detail.
Back to the point: are mutual funds becoming obsolete?
I think the answer is yes, but it will be a very slow death. More importantly, bad mutual funds - those that charge high fees and underperform peers and indexed alternatives - should become obsolete. Same for other structures, too.
Here are a few quick stats from Morningstar Direct that suggest this is exactly what is happening. I searched for all funds, which includes mutual funds and ETFs, that meet the following criteria:
Fees are above average or high relative to category peers
Belonged to one of these US Category groups: Allocation, International Equity, US Equity, Sector Equity, or Taxable Bond
Performance relative to peers, as of 12/31/2023, was in the bottom third for the last 3 and 5-year periods
Believe it or not, that group contained 1,559 funds. There are some duplicates in here due to multiples share classes, but it’s still a big number. In February 2021, or three years ago, investors had about $311 billion invested in these funds. And over the last three years, over $100 billion, or about ⅓ of their assets, has been pulled from these funds. Investors are voting with their money.
I’ll share one final consideration for mutual funds vs. other structures, and it is related to wealth transfer.
Mutual funds, stocks, and ETFs all receive a stepped up cost basis when the owner dies. But the owner of a mutual fund in a taxable account may have paid considerably more in tax along the way. Gains from ETFs and stocks are (usually) only taxed when they are sold. A hypothetical example may help.
Assume I buy 1,000 shares of a stock for $100 per share in a taxable account. The stock performs well, returning 10% per year for 40 years. It’s now worth $2.17 million. Assume I die at that point. My beneficiaries receive those shares and their basis is “stepped up” to the price on the day that I die. No tax is owed. That’s a very efficient transfer of wealth.
Now consider the mutual fund, which has to distribute gains in the year they are realized. I will owe tax each year that occurs and have to decide to pay the tax bill by selling shares, or using another source of funds. Regardless, it’s a potential drag on wealth creation.
I think good tax planning should count the amount of taxes paid over someone’s lifetime, not just in any given year. The mutual fund structure appears to be at a disadvantage from this perspective.
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