Mutual funds are probably the greatest invention that Wall Street has ever cooked up. Oh sure, they make plenty of money on them and some money managers have really stunk up the joint over the years, but by and large mutual funds have proven to be a fantastic invention. While many of our regular readers here at Primerates.com may find it difficult to believe, many people (dare I say most people) have no desire to learn about stocks and bonds or anything else investment related. That is not to say they don’t want to want to care, because it does seem like something adults should care about. It’s just that the topic bores them to no end. Further, there are also many that have dipped their toe in the water, often by buying a stock on a “hot tip” or just a (momentarily) “hot stock” and decided that this investment stuff is just too difficult and no fun.
But again, most people know that they should care and that’s where mutual funds come in. For just a few dollars a customer can own a piece of hundreds of different stocks. In addition, they don’t have to make any decisions on the individual companies in the portfolio, as a professional money managers handle that chore. One can argue about the need for a manager at all in today’s index fund and ETF world, and one can certainly complain about the fees that some funds charge. Overall though the idea was, and still is, a brilliant breakthrough for a large chunk of the population. There are many an IRA and 401K that would be worth far, far less today if the choice to use a mutual fund to buy stocks was not available.
However, there are certainly some negatives involved with the product, even beyond the aforementioned manager performance and fees. But there is one inherent flaw in mutual funds that is rarely mentioned. I am going to concentrate on bond funds in this post, but it really applies to all types of funds, including those that use “leverage” to “enhance” returns. With bond rates (and savings accounts, CDs, etc) at or near historic lows, there does seem to be some built in danger involved specifically with these types of mutual funds. After all, while interest rates can theoretically go into negative territory, for obvious reasons, even bond holders are generally not rooting for that to happen. After all, if institutions are willing to take your money only if you agree ahead of time to take less whenever you want it back then there are some serious economic problems going on.
Alright, so what is this so-called flaw? Well, it’s really very simple, during times of panic, or at least a solid rush of people wanting out, the money manager is forced to give you your money. Normally, this is no big deal and just represents the common ebbs and flows that funds have dealt with for decades. The problem is that, in times of large selling, the money manager may see a perfect time to load up on bonds, but he has no choice but to keep selling the fund’s holding to meet the demand from their customers. Many funds are further constrained in that they must keep a certain asset allocation, so as a large wave of redemption orders flood in, the money manager must sell everything, even those holdings that she might think have the best chance to bounce back. So, for those investors who want to hold onto their fund, the money managers they hired to run the fund are selling when they want to be buying. For a time, they are essentially just order takers and they simply cannot do what they think is best for you, the customer.
And for those people that just had to get out no matter what, there could be a little surprise in store. As the price of your bond fund goes lower and lower and more and more people head for the exits, the manager must sell. Usually this is a non event, but the mutual fund may have bought a lot of the bonds in the portfolio many years before and during that time they have crept closer and closer to their maturity date. After this five year bull market in bonds that scenario is a real possibility. So, while everyone is selling, and bonds are tanking in price, the manager must sell these older bonds. And the thing is, those bonds, while down, may very well be profitable. And taxes are based on the capital gains of the fund, not just your gains or losses. What that means is that you could sell your bond fund at a loss (or breakeven for that matter) and still be hit with a large capital gain bill at the end of the year from your fund company. Now, it is important to note that the mutual fund companies are well aware of this tic in the system and generally do everything they can to avoid it. If possible, they will sell the losses just so that scenario doesn’t occur. But sometimes it is just not possible. While this bull market in bonds has been on the unique side, this kind of thing happens to stocks more regularly and on more than a few occasions, fund holders have been hit with a tax bill on funds that had taken a huge dive.
The bottom line is be careful. As always, try to be ready for everything. If you have found yourself with more bonds than you are comfortable with, it’s far better to sell some of those now. Once (or if) the stampede to get out begins, there are not a lot of good choices to be had.