Conclusion
There are still some funds that have kept expenses low and do not charge load fees. But in my opinion that does not make up for their inability to be selective and flexible enough to perform well. I believe ETFs offer a better alternative for the safety net of diversification. I also believe that carefully screening and choosing individual stocks for growth at a reasonable price is preferable to owning mutual funds.

The Details
Fees and expenses of mutual funds are increasing, making it even more difficult to profit. My rule of thumb for what is an acceptable expense ratio, the cost of running a fund, has been less than 1%, unless the fund’s performance is so good, a higher chunk out of profits is not painful. Many well-run funds are seeing their transaction costs increase as they make more changes to the portfolio than they have had to in the past.

As for fees, more and more funds are adding front-end load fees in order to compensate for the overall loss of investors they have experienced. (These fees are charged at the time the fund is purchased and are generally between 5% and 6%. For example, an investor pays $5,000 to buy a mutual fund; $250 - $300 is taken out immediately, and only $4,700 - $4,750 worth of the fund is purchased.)

Funds that replicate indexes typically have the lowest fees, which is one reason why they are so popular. The Vanguard 500 Index has an expense ratio of .18%.

Dividends paid by underlying stocks in mutual funds are first used to pay the fund’s expenses before the remainder makes its way to individual shareholders. As an example: Morningstar recently posted data from Longleaf Partners’ Statement of Operations, which revealed that of the $34 million the fund received in dividends, only $8.25 million was distributed to shareholders in 2002.*

Retirement Plan Choices are often primarily a list of mutual funds. This may change. If you are trying to make the best choices from a list of mutual funds, I have written some tips on how to make the most of these choices when you revisit your 401(k).


*Morningstar.com, "Where Have My Dividends Gone?" 4/16/03.

NEGATIVE ON MUTUAL FUNDS
While I am optimistic about a return to growth in the stock market, as the economy recovers, I believe that growth will come selectively. The (successful) end of the war will boost consumer confidence, which should be good for the market. The first quarter earnings season, currently underway, may temper some of that enthusiasm, as there will certainly be some disappointing earnings reports. However, most estimates are for a 3-5% profit growth for the quarter, which, while not outstanding, is still growth. And GDP for 2002 rose 2.4%, indicating a sluggish but growing economy.

Since most mutual funds own very large portfolios, and they usually have to invest according to a somewhat restrictive objective, such as large growth stocks, foreign stocks, or a balance of stocks and bonds, they cannot be nimble or selective enough to really benefit from the relatively small pockets of growth I expect in the market.

Diversification is still key to reducing risk. But owning every S&P 500 stock can be an anchor in a slow-growth market. Identifying and owning sectors that are poised to benefit from current economic or political situations can provide both diversification and growth. An industry sector can be purchased in the form of an exchange traded fund (ETF), a basket of securities (usually a dozen or two) from one sector. Likewise, exposure to that sector can be reduced or eliminated in one transaction like selling a stock—with a commission, but with no deferred or redemption fee, which many mutual funds have. You can even build a portfolio of stocks using ETFs, rebalancing among sectors as market conditions warrant.