Chapter 6: Mutual Funds and ETFs
Let's start with the basics. When you invest a certain amount in a mutual fund, you pool your money together with other investors. A fund manager with market knowledge then distributes this pooled money across various stocks as they see fit.
The manager actively manages the portfolio to react to market conditions, aiming to optimize returns. They charge an annual percentage fee for this service, typically between 0.5% and 2%.
This sounds great in theory
The key idea is that, in theory, mutual funds should provide good returns through active management. However, in reality, mutual funds fail to outperform the market over longer periods in almost 90% of cases. At Wealthy Workers, we never recommend investing in such funds, and we want to support this bold claim with some facts:
Underperformance
There are multiple reasons why mutual funds are problematic, but they all boil down to one main issue: underperformance. About 90% of mutual funds underperform over a 20-year period, and those that do outperform often do so more due to luck than skill. If you don't believe us, search for studies on mutual fund underperformance, and you'll see the evidence.
This underperformance defeats the whole purpose of investing in a mutual fund since the high management fees are supposed to justify the fund's ability to outperform the market.
The main reason for their underperformance are stated on the right
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Mutual funds often have high fees, including management and administrative costs, which can significantly reduce your overall returns. Even if the fund slightly outperforms the market, these gains might not be enough to offset the fees. For the investment to be worthwhile, the fund needs to outperform the market by a significant margin; otherwise, the fees can erode your profits.
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Mutual funds often rely on conventional wisdom because most fund managers have been trained in similar schools of thought about the market. This can lead to a common approach to what they invest in and avoid. As a result, they tend to be conservative and highly cautious of volatility, which can limit their potential for higher returns and cause them to underperform over time.
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Mutual funds must adhere to certain rules, such as annual rebalancing, which ensures that no single holding dominates the portfolio. This practice can hinder gains, as it prevents the fund from fully capitalizing on momentum by selling off high-performing assets too early. Additionally, mutual funds often feel pressured to show gains each year, limiting their ability to hold onto potential big winners that may take years to realize their full value. This short-term focus can restrict their ability to achieve significant long-term gains.