The Mutual Fund industry has been a marketing juggernaut since the mid-1980’s. Billions of dollars have been deposited into mutual funds, but that decision by many investors may have cost them more than they realized. There are many reasons why mutual funds are not everything they market themselves to be.

1. Underperformance.

From 1992 through 2002, growth-orientated mutual funds averaged 8.5% returns compared to an average annual return of 9.68% for the S&P 500 Index. Certainly, in any given year, some mutual funds outperform the market; however, the vast majority do not. Further, the average mutual fund investor will frequently sell an underperforming fund in an attempt to find that elusive ‘best performing’ fund which only incurs redemption fees, sales charges, and taxes which, in turn, drags their returns even lower.

2. Transparency.

Currently, mutual funds only report their holdings on annual, semi-annual, or quarterly basis. By the time, the fund owner is in possession of those reports, the fund’s holdings have likely changed dramatically. Further, it is a common practice for funds to ‘window dress’ their holding just prior to the release of a report.

Transparency of fees and expenses is also a problem with mutual funds. While management fees and sales charges are widely accessible, other fees, such as 12b-1 and trading fees are often difficult to uncover. Most fund owners are not aware that each investment trade a mutual fund makes incurs a trading fee which is paid by the fund and further pulls downs the investors’ returns.

3. Lack of Access to Your Money Manger.

Most mutual fund investors know their broker or financial planner and regularly speak with them. However, these professionals have no control or influence over the underlying securities held by a mutual fund. The fund manager is ultimately in control of the investment selection, and the average investor has no access to this individual.

4. Over-Diversification.

Mutual funds are required by law to ‘diversify’ 75% of their assets. Diversification is defined as having no more than 5% of the portfolio in any single security and having no more than 10% of the outstanding shares of that security. Due to the size of some funds, many fund managers are forced to invest in more than 100 different stocks with the largest funds having positions in well over 175 stocks. Does that mean that the fund manager has 175 stocks that he thinks are ‘great buy opportunities’? Unlikely. The fund manager is often forced to buy lesser quality stocks in order to keep the fund ‘diversified’.

5. Fund Overlap.

Many mutual fund investors will place assets in several different funds. Perhaps the investor has bought a growth fund, a balanced fund and a small-cap stock. The investor would be surprised to find that many stocks held by one fund are also held by the other funds. However, this is often the case. The investor may have attempted to diversify across several funds only to find that he owns the same stocks over and over.

6. Cash Requirements.

The prospectus of a mutual fund will establish a minimum and maximum cash position the fund can take. The fund must adhere to this self-imposed requirement. This limits the fund managers investment options during market downturns. In longer ‘bear’ markets, most prudent investors would move their investments into greater cash positions.

At the height of the market in the year 2000, the average mutual fund had only 4% of their portfolio in cash. This figure exceeded 6% only once for any given month during the following two-year bear market. The S&P 500 lost nearly half its value, but fund managers were forced to either keep a position in a stock that was plummeting in value or sell that stock and buy another stock that would likely lose value as well.

To compound the problem, many of the stocks that were sold off by funds during the bear market, were sold at a net profit from their original purchase price even though they had declined in value that year. At the end of the year, investors had not only watched their portfolios decline in value rather dramatically, but they were also handed a capital gains tax liability. Speaking of taxes.

7. Taxes.

With Mutual Funds, an investor exposes themselves to two different tax situations. The first is capital gains tax on the increase in price of the fund above the investors cost basis in the fund. If an investor purchases a fund at $10 per share and then later sells the fund at $11 per share, the investor will pay capitals gains taxes on $1 per share.

The second tax, often overlooked by investors, is the capital gains distributions that a mutual fund places upon its shareholders once a year. These distributions are not given to the shareholders that owned the fund at the time the capital gains was incurred, but rather to the shareholders at the time of distribution. When an investor purchases a fund, the investor is also assuming the tax liability for all capitals gains incurred since the last distribution.

For example, ABC Mutual Fund sells a holding on May 1st for a gain. Jane Investor purchases 100 shares of ABC Mutual Fund on July 1st. John Investor, who originally purchased 100 shares of ABC Mutual Fund on January 1st, sells all of his shares on August 1st. Guess who gets to pay for that capital gain incurred on May 1st? Jane does when the distributions of capital gains are made later in the year.

According to a release by the SEC in 2006, mutual fund investors lose 2.5% of their returns to taxes on embedded capital gains each year. While these taxes must be disclosed in a mutual fund’s prospectus, these taxes are often excluded from the returns the funds highlight in brochures and advertisements.

What alternatives do investors have to mutual funds?

For investors with over $100,000 of investable assets, separate accounts are an excellent alternative. These accounts are managed by professional money managers with whom the investor will often have direct access. In a separate account, the investor owns the underlying security; has greater control over when taxes are incurred; and has complete transparency of investments. Further, separate accounts have management fees that are often lower than mutual funds and have little to no expenses or additional fees which may affect portfolio performance.

Mutual funds are wildly popular and undoubtedly can make investors a profit. However, for the informed investor, separate accounts can achieve the diversification often sought in mutual funds while avoiding the inherent short-comings of mutual funds.

Bio: John O’Byrne, J.D. is the President and Chief Investment Officer of O’Byrne Williams Capital Group, Inc., an investment advisory firm specializing in global portfolio management. For more information, please visit http://www.obyrnewilliams.com