Why you should ditch your mutual funds now

Mutual funds have helped introduce the masses to stocks and have played a big role in portfolios for individual investors. However, they appear to be well past prime time.

In 2015 the S&P 500 Index posted a meager total return of 1.4 percent, including dividends. And yet 66 percent of actively managed large-company stock funds were unable to exceed even that low bar, according to the SPIVA U.S. Scorecard.

Yet seemingly every year, articles in the financial media assure us that this will be the year of the stock picker. Asset managers selling droves of mutual funds furiously research the reasons for yet another year of underperformance, and they are quick to identify mounting "evidence" that the environment is about to change to benefit professional stock pickers.

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But rather than looking for elaborate excuses, maybe it's time to draw a different conclusion. Perhaps actively managed mutual funds are no longer the best way to gain exposure to equities and fixed-income asset classes. Quite simply, it's no longer prime time for the mutual fund industry.

The modern mutual fund concept as we know it — pooling capital from investors to buy securities — dates back almost 100 years. Over the decades, investors have periodically embraced and eschewed these investment vehicles, but it wasn't until the late 1970s that widespread interest in the stock market began propelled select fund managers to rock-star status. Maybe that was the beginning of the end.

According to the Mutual Fund Education Alliance, the benefits of investing in mutual funds include the ability to harness professional money managers' expertise, diversification, affordability and low (typically) minimum investment thresholds, and accessibility and liquidity.

That all sounds good, and there's no doubt the mutual fund industry should be applauded for educating investors and providing a gateway to participate in the public ownership of growing companies.

But the financial services industry is dynamic, and at some point investors need to step back and ask themselves: "Are today's actively managed mutual fund offerings still attractive, and should investors continue to allocate to these vehicles?"

Perhaps with the exception of select strategies or niche sub-asset classes, I believe that today's actively managed open-end mutual funds offer a poor value proposition. Let me count the ways:

1. Performance. Nobody likes to be average, and the mutual fund industry has done its best to exploit the notion that investors should not settle for the average performance of broad market indices. Unfortunately, actively managed mutual funds have, for the most part, delivered worse than average performance. Year after year a shocking number of actively managed funds underperform their respective benchmarks. The data is quite damning.

For example, Morningstar's Active/Passive Barometer, a semiannual report that measures the performance of U.S. active managers against their passive peers, "finds that actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons, and experienced higher mortality rates (i.e. many are merged or closed)."

2. Tax inefficiency. Mutual funds are highly tax-inefficient vehicles, even patently unfair to some investors. In any investment vehicle that pools assets, expenses and tax liabilities are shared across all shareholders of record, regardless of the date of purchase or length of ownership.

Consider what that means for today's investors. Seven years into a bull market, most mutual funds will have their share of winners that they have owned for years. If a fund manager wants to lock in profits or otherwise exit a position, there will be tax consequences.

But any investor who allocates new capital to this fund in the same calendar year that the fund sells that position, that investor may be forced to share in the tax liability even though he or she did not benefit from the rise in that company's share price. Who wants to be allocated a full ration of capital gains without receiving the profits? That doesn't sound like efficiency to me.

3. Transparency (or lack thereof). Do you really know what's inside your mutual fund? I challenge you to look up the top 10 holdings from your funds that advertise different investment philosophies and styles. It's highly likely that your "Value" manager and your "Growth" manager, for example, may be buying many of the same stocks, but for different reasons. How much cross-ownership of individual companies are in your portfolio? Suddenly that diversification benefit touted by the mutual fund industry may not be so clean.

And what about "scope creep," or "style drift," as it's known in the business? There's no question that investors tend to chase performance, for better or worse. The hot funds raise gobs of capital after a short period of outperformance. But suddenly that same fund needs to loosen its investment parameters or alter its philosophy just to put its windfall of capital to work. Successful funds often become a victim of their own success, and that's why performance tends to revert to the mean.

4. Fees. Paying a skilled professional to exploit inefficiencies in the market sounds reasonable until you do the math. A front-end fee of 4.75 percent, not uncommon for an active fund, means you are only really investing 95 cents for every dollar. In effect, you are starting with a negative return. That fund manager must be able to deliver significant alpha (excess returns above the benchmark) just to get back to even.

And when you consider the higher expense ratios relative to passive strategies, the value proposition starts to look murky at best. Some managers might obfuscate the fee issue with discussions of risk, but the one rule that remains is caveat emptor.

I believe that many asset managers today are using high-fee, actively managed mutual funds as tools to enrich insiders. Repeated poor performance, unfair treatment of tax liabilities, high costs and other inherent flaws make most mutual funds a poor value proposition. Index funds and specialty strategies may be exceptions, and there are always a few managers with legitimate stock-picking skills. But it's virtually impossible to construct a portfolio selecting only top-performing mutual funds.

That's why there has been a fundamental shift in investors' thinking and behavior, which has been evidenced by the massive flows out of actively managed funds and into passive strategies.

We are still in the middle innings of this paradigm shift, but you don't need to be the last one out. Now may be a good time to consider building a portfolio around lower-cost, exchange-traded funds or index mutual funds, coupled with a customized selection of individual securities.

— By Bill Harris, CEO of Personal Capital