Tuesday, June 11, 1996
Mutual Funds -- Are They Really So Bad?
By MF Runkle

It seems the chats I host cause me to think a lot, which is somewhat painful, but I'm getting used to it. My chat, "Foolishness on a Budget" is aimed at the little investor. In the most recent chat, the topic of mutual funds came up. I admitted that I have investments in some mutual funds, and sure enough, MF Wired was hiding in the room. He jumped out and laughed at me for my heresy. Well, he had little room to talk, he has NO shares of Iomega. HA!

Anyway, getting back to the subject of mutual funds, are they bad? What about a real small investor who only has $1,000 to invest? Lets go further, what about the beginning investor, with $50 or $100 to start. Wouldn't it be better to put that in a mutual fund, and diversify the risk? The Vanguard S&P 500 is a good fund, but they have rather high minimum investment requirements. A non-IRA account requires $3,000 (IRA - $1,000). Some of your other mutual funds have much lower thresholds to start. Also, some have quite impressive returns.

Considering this, what is so bad about going into a good mutual fund? Let's start with the track record for funds. Most fail to beat the S&P 500 index. There are a number of reasons for this. John Bogle, who came up with the Index Fund idea and is the former CEO of Vanguard, has written a book on the subject. For the most part, he blames fund under-performance on efficient markets. In other words, the stock market is fairly efficient, stocks are fairly well valued, and no fund manager can beat the market over a long period of time. That is probably somewhat valid.

Still searching for the answer, I read Peter Lynch's books. Lynch talks about all sorts of barriers fund managers must deal with. Funds have many restrictions on what the manager can invest in. They're limited by how much of their portfolio can be in any one position as well as how much of any one company's outstanding shares they can own. If they were to buy too many shares of a thinly traded small cap, the stock goes nuts. As the fund gets larger, it is forced into buying lower quality stocks. Some are restricted to "socially responsible investments". Finally, fund managers aren't all superstars; most are mediocre people doing a mediocre job, getting mediocre returns.

So, even if the fund you chose has beaten the S&P 500 for the past 20 years, "past performance doesn't guarantee ...." The manager could be replaced by a total idiot. Or, the fund could get so big that it has to invest in everything on the planet, becoming a de-facto index fund with higher management costs. You could invest in a fund which does well for a couple of years and then starts to tank. If you take your money out, you've got a taxable event and more money is lost to capital gains. That's why I'm still in the mutual funds from my pre-Foolish days.

What's a little investor to do? If I could do it all over again, I would put my money in a Dividend Reinvestment Plan and forget about mutual funds. Some very good companies, like Texaco and Proctor and Gamble, allow you to buy stock directly from them (Texaco $250 minimum, P&G $100). The National Association of Investment Clubs will get you the first share of many good companies for a token fee; I understand it's $7 now.

Better yet, a lot of blue chip companies have beaten the S&P 500 index over the years. Over 5 years, Texaco (10.8%) hasn't, but checking my S&P Stock Guide, let's see about some other DRiP stocks. Proctor and Gamble -- 16.8%, Coca Cola -- 28.1%, Exxon -- 14.5%, General Electric -- 23.8%. The S&P 500 index for the same 60-month period is 16.6%. So, out of 5 DRiP stocks I chose off the top of my head, 3 beat the index. Two of the three, Proctor & Gamble and General Electric are very diversified companies, and quite well managed.

If I were starting today with $100, I would start a DRiP in a well diversified company, with a track record of beating the S&P 500. I would forget about the mutual funds (including index funds) completely. Of course, if you really would feel more comfortable with a mutual fund, go ahead. If you check the fund out in Morningstar, you shouldn't do badly. Even if you don't beat the S&P 500, the world won't end. Most funds will do better long-term than a savings account. And if MF Wired gives you any grief, just ask him how his Iomega stock is doing.

Transmitted: 6/11/96