2010 To-Do-List for Fund Investors
By Ron DeLegge
January 7, 2010

SAN DIEGO (ETFguide.com) – In 2010 everyone will be exactly one-year older, but will they be any smarter? This is a good question, especially for mutual fund investors.

Today, around $11 trillion has been socked away into mutual funds. Some of this money is invested in taxable accounts. Other money is in tax-deferred retirement accounts like IRA and 401(k) plans. People are banking their financial futures on mutual funds. But are they really getting their money’s worth?

Here’s a 2010 to-do-list for mutual fund investors:

Ignore Mutual Fund Ratings
Will buying highly rated mutual funds (4 and 5 star funds) guarantee your financial success? Not according to new research compiled by Advisor Perspectives.

From 2007-09 the company calculated the probabilities that highly rated Morningstar funds would produce better predictive results in various investment categories. What did they find? Instead of proving that top-rated funds provide the best future performance, the study concluded, “funds given 5-stars did not perform well in a number of categories.” Furthermore, 5-star rated taxable bond funds (NYSEArca: AGG) international funds (NYSEArca: EFA) and municipal bonds (NYSEArca: MUB) showed the lowest raw returns of all star categories.

What’s the lesson? It’s that mutual fund ratings are more useful to fund companies than they are to investors. Fund ratings are nothing more than a sales tool to market and sell mutual fund investments to hindsight looking investors who don’t know any better. Don’t be one of them.

Stop Chasing Performance
Over the past ten years large cap U.S. stocks (NYSEArca: SPY) delivered an unappetizing negative 24.1% loss. Meanwhile, the “best” performing stock mutual fund of the decade, the CGM Focus Fund (Nasdaq: CGMFX) rose around 18%. How did CGM’s investors do?

The “investor returns” recorded by Morningstar show the prototypical CGM shareholder losing roughly 11% annually. How can that be? Investor returns are a more accurate reflection of what type of performance mutual fund investors are really getting because it accounts for cash inflows and outflows into the fund.

The losses experienced by CGM’s shareholders are an excellent case study for the foolishness of chasing a mutual fund’s hot returns. Buying at the peak and selling at the bottom still doesn’t work, even for investments supervised by hot shot fund managers. 

Quit Trusting in Financial Regulators to Protect You
By now we should all know that financial regulators like the Securities and Exchange Commission or S.E.C. aren’t very good at protecting the public from financial crackpots and gypsies. Instead of preventing billion dollar investment schemes, the S.E.C. in some cases, looks the other way. Isn’t this one of the reasons why Bernard Madoff was able to pull off his $50 billion heist for so long?

In some cases, financial regulators contribute to shakedown. Look no further than a little know mutual fund rule called “12b-1”, which the S.E.C. helped to invent during the 1980s. The original purpose was to help the mutual fund industry to grow its asset base. While it’s done that, it’s also helped the industry to fatten its wallets. In his just updated edition of “Common Sense on Mutual Funds”, author John Bogle estimates that these obscure 12b-1 fees sucked around $28 billion from mutual fund investors in 2009.

In some cases, 12b-1 marketing fees are being charged to investors in mutual funds that are closed to new investment or no longer openly marketing themselves! Imagine paying an ongoing fee for a service that’s no longer being provided to you. Meanwhile, the S.E.C. talks a tough game about protecting investors from Wall Street, but bureaucracy and gridlock reign.

The best way to avoid 12b-1 fees is to not buy funds that charge them. And finally, a good defense for mutual fund investors isn’t the S.E.C. or any other financial watchdogs, but good education and a correctly aligned investment philosophy. 

Play the Game the Right Way
Even with a formidable research staff and virtually unlimited resources, most mutual funds still can’t consistently beat their corresponding benchmark over the long haul. Why? Because taxes, management fees and other hidden costs confiscate  returns, leaving investors with substandard results. What can you do to avoid this?

The best way to improve your odds of financial success is by owning a diverse lineup of low cost index funds or index ETFs. Even during the bear market episode of 2008, many fully invested index funds outperformed managed funds. What does it mean? If all or the majority of your investment portfolio doesn’t consist of an indexing strategy, you could be playing yourself right into Wall Street’s vulturous hands.

Conclusion
What kind of year will 2010 turn out to be for you? Will you be like most mutual fund investors and end up underperforming versus the market? Will you become your own worst enemy by chasing last year’s winners? Or will you thrive?

Whether we like it or not, each of us will be one-year older in 2010. But will we be smarter? The value of our investment portfolios in future years will tell us the answer to that question.