Why Mutual Funds and Index Funds are Bad Investments?

It was at lunch time when I decided to go to the bank to send our payments for the wedding. There was a lot of people in queue, even in the priority and preferred client’s lane. So I went to the manager’s desk, while waiting, and ask a few things about loans. I am planning to get a house for ourselves after the wedding. So after the discussion about the loans, the manager of the bank asked me if I would be interested in investments? “Sure” I said. She pointed me to a lady that would explain to me everything about the investment they are offering. Lo and behold, they offered me the insurance + investments (VUL) that are popular these days. I heard they have large commissions that’s why the hard push for the product. But its not the reason why I write this post.

The life insurance part of the product is very subjective. Some people need it. Some don’t. The investment part is probably one that I can accurately judge if its good or not. And you can buy those investments (mutual funds, UITFs) separately if you are so inclined and cost less. What caught my attention was that they are offering index funds now. They weren’t available in the Philippines 5 or so years ago. I know this because I was looking for it back then. So looking at these products I realized that they are not such good investments like I thought they would, and let me tell you why.

Mutual Funds

These actively managed mutual funds charge 1% to 2% per year in management fees. That may sound small but over the long term and depending on the amount you invest, it could spell a difference in millions. That’s not something you should hold on for the long term. And these prospectuses projected returns of 4% to 10% per year. The disclaimers pronounced “Past performance does not guarantee future performance” that only means you can confidently say, that they certainly won’t be returning 10% per year. There was as study that tracked all the mutual funds in the United States and compared them to the Index. The statistics say that 90% of all fund managers in these mutual funds can’t beat the index. In the Philippines, the number is more like 95%. So why bother? Just buy the index then. There’s no value added and they charge higher fees. Mutual funds are definitely a bad investment in that regard (or any kind of mutual funds and UITF).

Index Funds

Ok, so if mutual funds are bad and they can’t beat the index. We should just buy the index and be done with it right? Yes. That’s the popular opinion. Warren Buffett recommends that. And surprisingly enough, I do too. BUT. I don’t index, neither do Mr. Buffett. Why? Because there’s no value added and a value investor can do better.

Index funds could be the only way to invest if you have given up hope looking for companies.

What do you mean value added? I mean, I give my money to the index fund managers right? Right. And they charge me a fee for managing that. My returns would be the same as with the index less the management fee. But the index is just a list. There’s no work required in copying a list of stocks. The index fund managers don’t work. They don’t do research. They just copy a list and they charge a fee. Charlie Munger calls this fee, “a fee just for breathing”. So its also bad. Why not just copy it for myself. No fees and done.

But its not all bad. If you’re a value investor, index funds could be the only way to invest if you have given up hope looking for companies. And I do plan to do that, if I feel like I’m losing it, I might just put it in my own index fund and just be done with it. But until that time comes, I’ll be looking for value investments.

In Summary

Any kind of mutual fund is a bad investment, in my opinion, except for index funds. But index funds are for people who gave up investing so its also bad for value investors.

But you just said that 95% of professional investors can’t beat the index. What chance do I have to do better? You can definitely beat the index if you follow the value investing strategies found on this blog and books. I know that every personal finance and nerds nowadays preach index fund investing like the 2nd coming of Christ. But there’s always something bad happens, when most people, especially the crowd agrees on things.

3 comments

  1. I started doing investing in stocks because I want a personal touch and learning out of it. In fact, my TEL (in red) will always reminds me of my naivety when I just got started. Having TEL in red for several years now teaches me that prices can go down. Its a good experience. But I’m still getting dividend out of it. Last year, I’m thinking of experimenting. Probably get a mutual fund (equity or index) to compare if it will be better than the stocks that I personally manage.

    Now I’m acquiring all information I can get. How it will give me a better return than my stocks. Your blog here is a good perspective. Its taking me forever to read all prospectus of Mutual Fund companies (depending on the type of fund itself) but I’ll probably get short term conservative Money Market for cash that will be used next year.

    My arguments is same with yours. I’m always particular on cost vs benefit. And I just don’t trust people. Hahaha! By the Way, I had VUL (also a remnants of my naive days but I’ll stick with it because its already my 5th year with it and I still pay relatively cheaper because I started early) Would love to see topics about Health Insurance as well. 🙂

  2. I have to disagree with “index funds are for people who gave up investing”. For people who only have enough time to go through the financials of local companies but want to gain exposure in other markets, for example the United States, I believe Index funds are the key to gaining exposure there without feeling the pressure to analyze what already is quite a number of companies in the Philippines.

    I conduct my own analysis when it comes to my portfolio of PH securities and I do not have the time or knowledge when it comes to analyzing other foreign companies. This is why I opted to add to my portfolio Index funds that focus on the US & EU markets. And of course, I opted for the funds with the most competitive fees.

    Index funds should be an integral part of anyone’s portfolio.

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