A mutual fund was originally a financial tool used (and made available for) small investors. By small, I mean investors who didn't have a lot of money to buy into the stock market and diversify their investments accordingly. The mutual fund was a way for the average middle-class American to pool his money with other like-minded individuals and invest in a group of stocks (or bonds) and share in the gain or loss of the fund.

For years, mutual funds have been seen as the panacea for all of the world’s retirement ills. If we needed somewhere to put our retirement savings, there is - we are told - no better place to be than the latest, greatest, mutual fund. And, over the years, the mutual fund industry has changed to accommodate not only small time investors, but large ones as well.

With the many changes; however, came many new problems. Today, mutual funds are riddled with problems that are not often discussed with the general public. These problems are primarily restricted to managed mutual funds, but some of the problems you may find in all types of mutual funds. Some of these problems include:

1)    There are restrictions on your investment. By law, most stock positions in mutual funds cannot represent more than 5% of the fund (Source: The Trouble with Mutual Funds, Richard Rutner; 2003). Government regulations have forced this issue for over 60 years through various requirements and the result is that this 5% rule, allegedly designed to make mutual funds a diversified investment product, are actually diluting the performance as the 5% rule will only effect the best stocks in the portfolio.

This is because the stocks that perform the best will grow to more than 5% of the total portfolio value and must be sold. Meanwhile, the poor performers will continue to lose money. As the good stocks grow “too large” and are sold off, poorer performing stocks are brought in to replace them. This dilutes even the moderately good stock's performance. What you are left with is a diversified portfolio- a mix of poor performing stocks with a small amount of successful stock integrated into the fund.

2)    There is a special type of liquidity issue with mutual funds. Typically, a certain amount of investors' dollars are not invested in the underlying investments of the fund but are instead set aside for investors who want to pull out of the fund. By its very design, a mutual fund must do this so that it can maintain liquidity when investors want to sell.

After all, what good is it to own an investment if you can’t sell it when its performance has “topped out”? To cloud the issue, sometimes it's not exactly clear how much of your money is actually being put to work in the market and how much is held back for redemption requests (redemption is just a fancy word for selling your fund shares).

3)    Even if a significant amount of money is held in cash for redemption requests, there must be enough money invested in stocks, bonds, and other financial instruments to keep investors interested in investing in the mutual fund. If too many people choose to redeem their investments all at once, there may not be enough cash reserves to meet redemption requests. When this happens, the fund managers are forced to liquidate stock from the portfolio.

This, in turn, can have a negative impact on the entire fund and hurt your returns if the fund manager has to sell those shares at low prices to create liquidity. Additionally, mass sell offs can create temporary downward momentum. As the fund manager sells into declining prices, you are faced with losing money regardless of whether you keep the shares or sell them.

4)    The possibility (and high probability) of excessive capital gains tax compared to other investments. There is significant research that suggests that many investors sell when the market is down or try to time the market, but fail miserably. When investors sell in a down market, and the fund manager has to liquidate stock at low prices to meet redemption requests, the remaining investors in the fund also lose money because of the added capital gains tax that is assessed at the end of the year due to the excessive liquidation of the mutual fund's portfolio.

Even if the fund doesn’t need cash, excessive trading in an attempt to chase higher returns (to attract more investors) can have the same effect. In essence, it can create a situation where it is possible to lose money over the course of a year, and still owe capital gains tax because of the amount of trading that was going on inside the fund (Dalbar, Inc.'s Quantitative Analysis of Investor Behavior was first issued in 1995. The most recent update continues to show that individual investors are not realizing anywhere near market rates of return in stocks and bonds because of frequent switching among “hot” mutual funds and trying to time the market. Over a period when the S&P grew by 12.98%, the average investor earned only 3.51%. Source: DALBARinc.com).

5)    High transaction costs. Investors have, traditionally, continued to chase the highest returns in the market. To this end, funds have gotten the idea that they must stay “active” to keep the attraction of new investors and to try to “create” those high returns that investors want. This requires, in many instances, a lot of trading. But trading is not free. Just as if you were to buy individual stocks yourself, there is a cost associated with doing trades, even for fund managers.

This fee, of course will be passed on to you for your participation in the fund in the form of a transaction cost. Although many (if not most) funds - at this time - do not keep track of a stock’s bid/ask price at the time of a trade, it is estimated to be about .7% (Source: The Battle For The Soul of Capitalism; John Bogle, 2005; Common Sense on Mutual Funds; John Bogle, 2000).

6)    Mutual fund management companies are independently owned from the fund itself (they are two separate and distinct entities). Unfortunately, this can create an incentive problem. Fund managers have little incentive to help you make money because they are paid to maximize assets held in the fund. In other words, fund managers don’t have their interests aligned with investors.

This is partially because they are paid based on assets under management instead of being strictly performance-based. While an increase in performance would increase assets under management, increasing performance can be difficult, especially with transaction costs and a high trading volume to keep new investors coming into the fund (so the fund manager can keep his or her job).

The majority of fund managers find it difficult to “beat the market”. Many times, the return on investment for the fund company is better if they advertise to bring in new money rather than seek gains through asset appreciation.

The Only Real Solution

The index fund. Index funds are mutual funds that just track the performance of the stock market as a whole. This has not necessarily solved the problems with managed funds, but merely provided an alternative to the existing problems in the industry.

The real (and long-term, permanent) solution to these problems would be to get Government out of the business of investments and let the business world reign in bad managerial practices by bringing fund manager compensation in line with investor objectives by basing fund manager's pay on fund performance, not marketing initiatives.

In other words, give management a stake in the fund. There's no need for Government interference to solve the various problems, and it would force management to bring costs under control. The fund would become more efficient and both fund managers and investors would reap the benefits.