"Mutual fund investors should be offended by the amount of taxes and fees they have to pay," says O'Shaughnessy. "Mutual funds may seem like no-brainer investments but they can compromise your long-term savings potential. All the money you spend on fees and short-term capital gains taxes could have remained invested and compounding."
O'Shaughnessy has identified five big mutual fund drawbacks:
High expense ratios. Investors pay a fee for the privilege of owning shares. That fee goes to the fund's manager. But instead of a flat amount, the fee is based on your assets in the fund. The more money you have invested, the higher your fee.
Undisclosed transaction costs. This is the fee that a mutual fund pays to its broker to buy and sell stocks. The fee is not found in a fund's prospectus and is deducted from the fund's returns. The higher the fund's portfolio turnover rate, the higher its transaction costs.
No control. You have no say over what stocks the fund owns. Some stocks may be ideal for you while others are not.
Little knowledge. Because you don't know what specific assets a mutual fund owns on a daily basis, you could wind up owning the same stocks in several different funds. Or the types of stocks the fund buys now may differ from the ones it set out to buy when you originally invested.
Significant tax hits. In addition to the capital gains taxes you pay when your fund manager actively trades stocks, you also face "embedded capital gains." These can occur when a fund you recently bought sells a stock it has held for many years. Your tax hit on that trade will be equal to someone who has the same amount invested but owned the fund for many years and profited from that stock's long run-up in price.
What's the average mutual fund investor to do? Alternatives are emerging that provide individuals with more control over their investments and taxes. The Web-based services in this new "personal fund" sector offer stock portfolios that are tailored to an individual investor's personal financial goals.
Instead of buying mutual fund shares, investors in personal funds buy an entire portfolio of stocks for a relatively low minimum investment. By owning the stocks in a personal fund, you control your capital gains taxes by choosing when to buy and sell stocks. You also know at all times the stocks you own.
The low cost of ownership and individual control of tax responsibilities offer individuals significant advantages over mutual funds and other popular investment vehicles. As such, Forrester Research, an e-commerce research firm in Cambridge, Mass., predicted that more than $1 trillion will be invested in personalized funds rather than mutual funds over the next 10 years.
"The days when mutual fund investors have to eat what they are served are over," says O'Shaughnessy of Netfolio.com. "Personal funds make it possible for every individual investor to own a professionally selected stock portfolio that is reasonably priced and designed for their needs and goals."
