I ended up having some drinks with a friend of mine who has moved from the bank to an investment counsel firm. An investment counsel, in plain English, manages money for rich people (their legal standard of care is higher than an investment advisor and, with such higher exposure to liability, they charge higher fees; hence, their fee structure tends to cater only to well-off individuals). Before we had too much to drink and started waxing nostalgia about a more innocent time, we somehow started talking about mutual funds. His firm does not sell mutual funds: the first reason being is that rich people don’t want to be offered the same product as the mere plebeians like you and me (yeah, it is snobbish but its how the world works however unfair) and second reason is that the mutual fund model is simply broken.

It is always interesting to hear the view of insiders about certain investment products and his criticism of mutual funds serves as a reminder why we should not buy mutual funds and why the investment industry has recognized the model is broken and trying to sell new product instead (I have often thought that the ABCP fiasco became a larger problem than it should have because people became frustrated with mutual fund performance and were pressing their advisors for something different).  For the record, I started selling my mutual funds earlier this year and moving into ETF’s.

In no particular order, here’s what is wrong with mutual funds:

1. Most mutual fund managers are employees and not owners and have no incentive to beat their peers. Most mutual fund managers at large mutual fund companies are employee, albeit well-compensated employees. Think of your work-place; if you are an employee, you put in a professional effort but, as long as you collect your pay cheque, you are pretty much ok. Think of the owner of the business; they do well if their business does well. Thus, they have an extra incentive to go the extra mile. Financial Jungle did point out that mutual fund managers who are also owners of their fund tend to out-perform the market but this class of mutual funds is few and far between. Most mutual funds  are managed by employees which tends to mean they make safe choices and try not to rock the boat to keep their job (as the saying goes, no one ever got fired hiring IBM).
2. Most mutual funds are basically closet index funds. My friend point this out. The larger the mutual fund, the more likely they are buying stocks which consist large indexes like the S&P Industrials, the TSX 60 or the MCSI.  Why do you need to pay fees for someone to do this for you. An exchange traded fund (ETF) will do the same thing. But here’s the kicker as astutely pointed out by my friend: most mutual funds have to keep approximately 5-10% of their assets in cash to pay out redemptions so it is a closet index fund but not using 100 cents on your dollar.  A mutual fund could only be using 90 cents of your dollar to invest in a de facto index. That’s a lot of wastage for doing what you can do easily buying a ETF. 
3. The prime business of your mutual fund is not to manage your money but to sell more mutual funds. Eric Sprott is a bit of a local legend. His mutual funds do not hold any bank stocks or traditional blue chip stocks. Instead, he invests based on large macro-economic trends. His most recent successes being an early bet on gold and more recently on food. In a recent feature on Sprott’s management company, the article made an observation that Sprott Asset Management employs a lot of analysts (who research and make recommendations on stock to buy for a mutual fund) rather than on sales staff which apparently is opposite of the mutual fund industry. I scratched my head over this observation- you mean to tell me that the mutual fund industry is top-heavy on sales people rather than financial analysts? The obvious implication being the mutual fund is using our funds to sell more mutual funds rather than manage our money.
4. The fees are a killer. This dis-advantage to a mutual fund has been beaten into the ground: mutual funds charge high fees compared to performance, fees are paid if the mutual fund performs well or poorly etc. etc. But here’s some more food for thought- why are fees consistent no matter how much you invest? For example, why does a mutual fund charge 2% MER even if you invest, $500, $5,000 or $50,000 into a fund? Isn’t there an economy of scale if you invest $50,000 that should be reflected in lower fees? The conclusion being you are worse off the more money you invest in a mutual fund since you do not have any economies of scale (whereas in a stock purchase the commission is the same no matter how many stocks you buy).
5. You are not being sold the best mutual fund but the fund paying the best commission structure to the investment advisor or with the largest marketing budget. This is pretty self-explanatory.

If the rich don’t buy mutual funds, why should you?