Why Individual Stocks And Bonds May Serve You Better Than Mutual Funds

by Chris Cyr

Many Americans own mutual funds but are unaware of some important issues associated with them.

A mutual fund is like a chicken wrap. It’s a collection of individual investments wrapped in one package. The ingredients inside are generally stocks, and the average equity fund holds over 200 individual stocks. 

But what investors might not realize is that these mutual funds tend to underperform;  In the last five years, about 75% of large-cap mutual funds have underperformed the benchmark. This has been going on for years. 

Some other issues about mutual funds that investors should consider before jumping in:

• Expenses. There are all kinds. Annual fund operating expenses are unavoidable. They typically run from 0.25% to 1.5% of your investment in the fund per year. In most cases, investors will encounter a sales load, which is a commission you pay to third-party brokers when you buy or sell mutual fund shares. A-class shares, for example, have a front-end sales load of usually between 2 and 5% of the total investment. 

Other expenses may include account fees, redemption fees (if you sell shares within a short period of time after purchasing them), and purchase fees (distinct from a front-end sales load) exchange fees, and purchase fees. The tricky thing is, these expenses are usually buried inside a document called a prospectus, which can be lengthy and difficult to read. 

• Advisor level. There are five levels of financial advisors, and as you get into the upper tier, you’re going to get a much wider, more robust type of planning from the advisor. That would include planning for Social Security, Required Minimum Distributions, Roth conversions, estate, taxes, long-term care, etc.

But at the other end of the spectrum, mutual funds are a level-1 advisor’s best friend. That’s because mutual funds are managed by an outside third party, which is charging fees for that service. A level-1 advisor is initially picking five or six mutual funds based on what the client needs at that time. But after that, it can become easy for a level-1 advisor to lose focus on a client’s portfolio since they're not doing any of the heavy lifting with regard to the actual investment management. It’s more or less a “set-it-and-forget-it” mentality. That level-1 advisor is typically working for a national firm, and they’re not being compensated and graded on the performance of the client’s portfolio. Instead, they are judged by the quotas they are meeting or not meeting. When an investor learns this, they might ask, “If an outside company is actually managing my investments, and I own the same five or six mutual funds I owned 10 years ago, then what is my advisor doing for those additional fees they are charging?” That’s a good question! 

• Conflict of interest. Another issue with the level-1 advisor is that, in most cases, they have limited access to mutual funds, of which there are more than 10,000. Deep in the disclosures of their websites, they say they have limited access to what they can give you. Then if you read further, you’ll read about revenue sharing and what that means. Essentially, it’s telling you that as a level-1 advisor working for a national firm, they’re going to have a conflict of interest. They have a financial incentive to pick the investments that are going to make their firm the most money and make the advisor the most money. That’s a scary thing most people don’t realize when they work with a level-1 advisor and invest in mutual funds.  

Pros and cons of the 60-40 portfolio 

When I’m talking with someone about mutual funds, the last question is always, “If we’re not going to invest in mutual funds, what should we invest in?” The answer can be individual stocks and bonds. These two alternatives are what level-5 advisors across America often recommend for their clients. Individual stocks and bonds don’t come associated with those outside third-party fees. 

One of the most popular strategies recommended by financial advisors is the 60/40 portfolio, which contains 60% stocks and 40% bonds. It’s important, however, to consider the pros and cons of that approach when looking at your retirement needs and goals.

On the positive side, the 60/40 is simple to set up when purchasing the S&P 500 and U.S. Treasury Bonds. Additionally, bonds help balance the risk of equity investments, and the ratio of stocks to bonds typically offers steady growth over time. 

The downsides? Returns on the 60/40 portfolios are predicted to be lower in the coming decades than they have been in the past. How come? Inflation is one factor and projected slower growth in gross domestic product is another. Stocks can be volatile, and bonds tend to have low yields. 

But with people living longer now, many need a portfolio that will continue growing steadily to keep up with inflation, and over time, a 60/40 portfolio may not grow as much as a portfolio with 100% equities. And compounding interest earned with equities makes a big difference over the long term.

Meanwhile, some people who are educating themselves about mutual funds are slowly getting out of them. Mutual funds should be considered for an investment portfolio, but some additional thought and process should go into looking at alternatives such as individual stocks and bonds.

About Christian Cyr, CPA

Christian Cyr, CPA, is the president and chief investment officer at Cyr Financial. He is a financial professional who can offer investment and insurance products and services.  A certified public accountant for over 20 years, Cyr helps clients understand the prudent approaches for investing, building wealth, and retiring comfortably. He spent over 15 years in the corporate world as a chief financial officer before founding a Registered Investment Advisory firm with expertise in retirement planning. Cyr speaks to audiences nationwide about investing and retirement, and has been featured on Strategic Investor Radio, the National Association of Active Investment Managers' Shark Tank competition, and other media outlets. He has a master's in finance from the University of Illinois Chicago and a bachelor's in finance from Eastern Illinois University.