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Originally Posted by fobunited
A couple of things about mutual funds:
1. First, they are extremely tax inefficient. The reason behind this is how the cost basis is calculated come tax time. The original purpose behind mutual funds was for investors who could not afford to diversify enough through buying individual securities to pool money together into a mutual fund that would help diversify for them. However, when you buy individual stocks, you pay tax on the appreciate of the stock if/when you sell it. In a mutual fund, however, you pay taxes on the gains the mutual fund had on specific stock, even if you didn't participate in the gains because you bought the mutual fund later.
For example, a mutual fund buys Intel in 1990. You buy into the mutual fund in 2001. The tech market slumps, the mutual fund does poorly, and you sell out of the fund in 2004. You probably lost money on the individual Intel portion in your mutual fund, but you will have to pay taxes based on the mutual funds cost basis of Intel when they bought it in 1990.
2. Another problem with mutual funds is their lack of transparency. Pretty much all mutual funds will divulge how heavy they are in particular sectors as well as their top 10 holdings, but you're never going to see what's in the mutual fund on a regular basis. This becomes a problem when you're investing in multiple funds because you may have alot of overlap without knowing it.
3. An important thing when looking into mutual funds is turnover. This means how often and how much is the mutual fund buying/selling stock positions within the fund. The higher turnover ratio, the more you pay, however the less turnover, usually that means the less "up-to-date" you will be with current market trends. You want to find a mutual fund that has a good balance in turnover ratio and historical return.
4. Another thing to be careful about mutual funds are their loads, aka fees. Almost all mutual funds you can buy through a brokerage firm carry loads because that's how the fund company, the brokerage company, and especially the broker get paid! In almost ALL cases, NEVER buy B shares of a mutual fund. They may seem appealing because they do not charge an upfront fee when you buy into the mutual fund, but they have trailing fees and you're stuck in the mutual fund for a certain number of years without being able to sell out of it and not get penalized. The trailing fees usually add up to you paying more than a fund with front loaded fees. Most brokers will sell you A or C shares to make money off of you upfront, or sell you B shares to keep you as a client and make money off of you for the next couple of years.
My advice is to buy ETFs. They are more tax efficient than mutual funds and they have less turnover and more upfront about fees. If you DO want to buy mutual funds, as there are some good ones out there, I would consider walking into a Charles Schwab and asking them for their "Select List." This is a list that Schwab publishes every quarter that lists mutual funds that they have selected that carry NO LOADS. If you'd like, take that list to a broker of your choice that charges less per trade as long as they can carry the fund. If you have enough money, I would skip out on ETFs and Mutual Funds altogether, and get a Separately Managed Account. This is a product/service that most large brokeragehouses offer where you have a manager that manages your account and actively trades in your account, much like a mutual fund but you actually own all the positions, you have transparency in seeing everything you own, and you pay capital gains tax on the growth you participated in. You don't pay any trading fees, just a percentage, usually around 1.1-1.5%. Any higher, and you're usually getting ripped off. The only drawback is there's usually a minimum asset level. Most places are around $250,000-$500,000.
Hope this helps, and good luck to you. Feel free to PM me if you have any questions!
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Good information. Mutual funds are indeed better off for non-taxable accounts. However, some fund families have specific mutual funds that are "tax-managed" funds and are better suited for taxable accounts.
+1 for Charles Schwab.