by Archie M. Richards, Jr., CFP^®
November 1, 2004

Avoid stock mutual funds that are actively-managed. Use index funds or exchange-traded funds instead.

Actively-managed funds try to pick stocks that will outstrip the market. But they seldom achieve this, because of the following problems:

• The expenses of actively-managed funds are enormous. According to Lipper, the expense ratios for all stock funds average 1.68 percent per year. (In contrast, most index funds and ETFs charge less than 0.50 percent per year.) The profit margins of actively-managed funds are outrageously high - upwards of 50 percent.

• The average stock fund turns over its entire portfolio every 11 months. (The average index fund or ETF turns over its portfolio probably once a decade.) The extra buying and selling by actively-managed funds incurs commissions and other transaction costs. Jack Bogle, founder of Vanguard, believes that transaction costs reduce mutual fund returns by about 1.4 percent.

• When you first buy a fund, you may pay capital gains taxes even though you hold the fund at a loss. Let's say a fund performs well during 2004. You buy shares at the beginning of 2005. A week later, the fund sells some of its stocks and realizes profits. Assume that for the rest of 2005, the fund value falls. In the spring of 2006, even though you hold your shares at a loss, the fund notifies you that capital gains taxes are due. Why? Because the fund realized profits after you bought your shares. (This problem is far less likely to occur with index funds and ETFs.)

• The actual performance records of some actively-traded funds may be worse than the advertised records. Let's say a fund you hold has had a lousy performance and can't attract new investors. It is merged with a fund whose performance is better. The SEC permits the record of funds that are absorbed by other funds to be disregarded. Your newly-merged fund advertises a better performance than the one you've experienced. To some extent, the advertisement is deceitful.

Thousands of technology and other sector-focused mutual funds were created in the 1990s. Many of them have performed poorly. As a result, almost 2,500 funds have disappeared during the past three years.

According to the Center for Research in Security Prices at the University of Chicago, for the 10 years ended in 2003, the average annual gain for surviving U.S. stock funds was 8.8 percent. The gain for funds that no longer existed was only 7.2 percent.

• Some funds don't stick to the investment style that's described in their prospectuses. If the prospectus says that the fund holds large value stocks, for example, the fund isn't expected to buy small growth stocks. But some funds engage in this "style drift" anyway. Why? Because investors favor mutual funds that recently outstripped their peers. When a fund can boast about a good record, investors are inclined to buy it. Later, when the record deteriorates, the investors are slow to sell.

In semi-annual accountings, most mutual funds show that they hold the kinds of stocks they're supposed to hold. But the stocks held between accounting dates are not disclosed. During those periods, some funds sell stocks they're supposed to hold and buy "hot" stocks that are moving up. You may think you're buying a fund that sticks to a certain type of investment, but to some extent it may engage in style drift. Whether it does or not you can't determine. Plus, the extra buying and selling increases transaction costs.

To one degree or another, all these difficulties affect funds that are actively traded. Most of them perform worse than the market, especially because of higher costs.

These problems are avoided by index funds and exchange-traded funds. They don't try to beat the market; they just try to equal it. Their costs are low. They change their portfolios infrequently. They're unlikely to require payment of capital gains taxes even when the fund is losing. They don't merge, and they don't engage in style drift.

Never mind actively-traded funds. Stick to index funds and exchange-traded funds. You'll be better off.