Stocks vs Mutual Funds

Stocks vs Mutual Funds

Why Pick Individual Stocks Over Mutual Funds?

By Dr. Winton Felt

The investor can buy individual stocks or let somebody else manage his investments by investing in a mutual fund or by hiring a registered investment advisor to manage a separate individualized account. There are differences in transaction reporting, taxes, investment focus, timing of purchases and sales, and in the profits generated..

Some investors have told me that they prefer mutual funds to individual stocks because a fund’s price can be checked daily in the paper. Also, some feel it is simpler to invest in a fund because there is little paperwork to review (no confirmation slips to worry about). Others think that by investing in a no-load mutual fund they avoid the transaction fees of brokers. However, such arguments either make virtues out of the faults that are characteristic of mutual funds, or they are simply wrong.

For example, all mutual funds pay brokerage fees, and these may or may not be at discount brokerage rates. For example, a standard rate for buying 200 shares of a $50 stock would be about $192. Through a discount broker, the fee could be $6 to $10. Also, the average fund currently has an annual management fee of 1.43%. Even no-load funds charge, on average, over 1%. The brokerage fee and the management fee are separate fees, and they both come out of fund assets. These fees are the same for all investors, regardless of the amount invested. Most money managers who manage separate individual accounts, on the other hand, have a management fee of 1% for their smallest accounts, and their fee scales down to almost half that for their larger accounts. Individuals who manage their own accounts avoid management fees altogether.

Individualized portfolios either with or without the aid of a professional manager can also get better returns than a mutual fund because they do not have to invest in more than 100 stocks to get adequate diversification. They can focus on the most preferred stocks because they do not have a continuing cash inflow that must be employed in a single co-mingled account. That is, when any investor sends money to a fund, it must be invested for all shareholders. This often results in the continuing purchase of stocks that may no longer be at their best price for an initial investment.

An individual can do a better job for himself than a portfolio manager can if he has taken the time to acquire some investing experience and has done his homework. However, between the two basic types of portfolio manager, one is more likely to have extensive experience. Whether a person is the manager of a mutual fund or the manager of separate individualized accounts, he or she must be a registered investment advisor (RIA). Either way, they both must have the same qualifications to be registered. However, because of the huge turnover rate in the mutual fund industry, fund managers tend to be less experienced on average (of course there are many exceptions). The average fund manager has been in the business for only 3.5 years. It is a great advantage to have a portfolio manager who has experienced a few bear markets and survived. Registered investment advisors who manage individual accounts often come to their positions by a different route and generally have far more investment experience than most mutual fund managers.

Individually managed accounts (as opposed to co-mingled accounts) have better control over what they own (they can avoid companies they do not approve of on moral grounds if they wish) and over the timing of their buys and sells. For example, when was a portfolio manager, it was common practice to time a purchase to coincide with a stock’s reacting to support by “rebounding” off that support or with a stock’s “breakout” through overhead resistance. This practice was not particularly unique. The point is that both of these are situations when a stock is much more likely to have a positive surge than at most other times. In other words, money is more easily placed in a stock that is “ripe for the picking” in a separate account than in a regular mutual fund pooled account. Many firms pay attention to such details, but not all. To find such a manager, you have to ask questions about how stocks are selected and whether there are any timing criteria employed when purchases are made. If the response is vague or related to valuation measurements, then you may consider the answer to be “no.” In contrast to the individualized portfolio approach, the preferred approach of mutual funds is to accumulate or sell stocks over time at a wide range of prices. A registered investment advisor who manages separate accounts can do a much better job of purchase timing than can a mutual fund. However, an individual investor who knows a little about stock setup configurations can do a much better job for himself than even a registered investment advisor who manages individualized separate accounts.

There are also tax issues to consider. Let’s suppose your favorite mutual fund has grown 20% between January 1, 1999, and March 31, 1999. Assume you buy it on any date after March 31, and assume the fund has no significant appreciation for the rest of the year. You would be taxed on all the gains the fund had before you bought (in this case, the 20% gained between January 1 and March 31), even though you did not own the fund during those months. You inherit the taxes on those gains, but you do not inherit the gains. Here is the way it works. By law, the fund must distribute its capital gains to its shareholders. Its distribution to each shareholder will be in proportion to the amount each shareholder has invested, and not in proportion to the gain realized by the individual investor. In other words, if you invest after the gain is achieved, the fund will return to you part of the money you invested in the fund. The money returned to you will be an amount that represents your share of the capital gain (even though you did not really get the gain because it was achieved before your purchase). The IRS will then tax you on the return of your own money as if that money were a capital gain. It is not fair, but it is the law. This does not happen with individual stock portfolios.

There is also the matter of reporting. Mutual funds trade stocks throughout the year, making many transactions, of which you are told nothing. You do not know what the fund is buying or selling or how much the trades are costing, and your fund manager is not likely to give you an explanation should you ask why a certain transaction was made. On the other hand, with a professional portfolio manager who manages separate accounts, you generally get a confirmation report from your broker showing detailed information for everything that occurs in your account. If this is too much information for you, you could obtain the same level of transaction awareness provided by a mutual fund by simply throwing your trade confirmations away without looking at them. Confirmations are a benefit not a detriment.

Some like to be able to look up the price of their fund in the paper (though they usually do not actually do so). However, in most cases an individual can look at his brokerage account any time by going online, or he can call his broker and ask. A professional portfolio manager of separately managed accounts can give you valuation numbers for each position in your account and for your account as a whole on any day of the week. It is probably easier to make a phone call than it is to find your fund in the paper. Unless a person is extremely lazy or incapacitated, how can it be a big problem to look up individual stocks in the paper but be an easy matter to look up a number of mutual funds?

Those who have accounts that are individually managed (by themselves or by professionals) obtain more complete transaction reporting, better control over taxes, enhanced ability to focus investments, better timing of purchases and sales, and far more control over portfolio contents. These things are far more beneficial to investment outcome than being able to look up a fund’s price in the paper.