Why I Don't Like Mutual Funds

The WSJ says hundreds of mutual funds with criteria [bold added below] that supposedly exclude Apple (AAPL) have nevertheless bought the stock:

At least 50 small-cap and midcap mutual funds—which focus on small and midsize companies—own Apple, the world's largest company by market value, according to analyses for The Wall Street Journal by market-data firms Morningstar Inc. MORN +0.20% and Ipreo Holdings LLC. Non-U.S.-focused funds also own it. Apple doesn't pay a dividend, but about 40 dividend-focused funds hold its stock. And Apple shares can be found even in one high-yield bond fund.

The reason that funds are permitted to depart from their objectives:

Under a 2001 securities rule, managers like Mr. Bacarella [who's supposed to invest in companies valued under than $10 billion] can apportion up to 20% of their portfolios to investments that aren't part of their mandate.

AAPL is up 42% YTD, boosting the performance of funds that hold it.

This (mis)behavior illustrates why I own few mutual funds; often they deviate from their stated goals. I buy funds because I want exposure to a specific sector of the market; an individual stock like Apple I could purchase for myself. If an energy fund drops in value because of a decline in the price of oil, that's a risk I took knowingly. If the fund goes down because it holds a losing tech stock, that's not what I signed up for. Managers stray because they are tempted by out-of-their-bailiwick "opportunities" that turn out to be risky bets.

For the individual looking to do his own punting, conditions are more favorable to self-guided investment than ever before.

Commissions are much lower on stock transactions than are the expenses on a mutual fund. For example, at this moment one can buy 100 shares of Google for $62,504 and pay less than $10 in commissions to a discount broker.

Some mutual funds charge an upfront fee that can cost 1% ($625 in the above example using Google) or more for the "privilege" of using their expertise; all funds, including those without an upfront load, charge an ongoing management fee that would be at least $100 per year (.2% of asset value) on a $60,000 investment.

Widespread availability of financial information and tools make it easier and cheaper for individuals to perform their own analysis and make intelligent decisions.

Adequate diversification can be obtained by investing in 12 to 18 stocks. And because of low commissions on all transactions, including odd lots (less than 100 shares), one can obtain reasonable diversification on a self-managed portfolio of $50,000.

Caveat: some experts believe that diversification--which reduces the risk of a disastrous loss in too-few names--requires holding many more than 20 different stocks. (If an investor is very risk-averse, then he should stick with mutual funds or, frankly, not invest in stocks at all.)

One last consideration: the investor can exercise better control over his tax position. From personal experience the capital gain and ordinary income that flow through on a mutual fund's Form 1099, after the tax year has ended, could be significantly larger than expected, increasing one's tax bill (and high taxable income doesn't necessarily mean the fund has gone up in value). Those who hold individual stocks can monitor ordinary and capital gain income more easily and pay estimated taxes, if need be, to avoid underpayment penalties. © 2012 Stephen Yuen