Why You Should be Wary of Some Mutual Fund Critics

Not all mutual fund critics are created equal. On one hand, you have those who -- like many of the contributors to MoneyWatch -- point out the industry's shortcomings on their way toward encouraging investors to focus on costs in constructing a broadly diversified portfolio.

On the other hand, you have folks who highlight the industry's flaws in an effort to convince you to eschew mutual funds in favor of a different investment strategy -- usually one that they have a vested interest in you adopting.

If I may be so bold, I think investors are best served by listening and acting upon the former group's advice, and paying no mind to the latter.

There's no doubt that the fund industry offers critics a wide range of targets. Too many funds are much too expensive; the vast majority has and will continue to fall well short of their benchmarks; they're managed with little concern for tax efficiency; and they're marketed in a way that encourages investors to act upon their worst impulses, relegating those investors to returns that fall well short of the returns of the overall market.

That was the essential thrust of two columns written by the Motley Fool's Paul Elliott, the most recent of which ran on Townhall.com. In it, Elliott takes the industry to task for its bloated fees, citing John Bogle to illustrate just how devastating seemingly small differences in annual expenses can be over the long term.

All true, of course. But then Elliott offers up his alternative. Rather than trying to minimize expenses and maximize your share of the 8.5 percent expected stock market return over the long-term that Bogle foresees, Elliott writes that "I think we can do better ... especially if we buy the right stocks."

And just in case a reader wondered how they might identify the "right stocks" to earn those wonderful returns, Elliott offers up his solution -- a subscription to the Motley Fool Stock Advisor, which is available for the low, low price of just $149 per year. In the link to the newsletter that Elliott helpfully provides, readers will learn of the amazing returns earned on some of the newsletter's stock picks, some of which have appreciated by more than 1000 percent. Wow!

One is left to wonder, however, why the publishers of newsletters like this one bother sharing these hot picks with investors who pony up a few hundred bucks. It would seemingly be far more profitable for them to build up big positions in these stocks quietly, on their own, and then reap the big rewards. That, after all, is the tactic preferred by Warren Buffett, who likely wouldn't share his picks for $149 million, let alone $149.

The reason newsletter publishers sell their predictions is not because they're naturally philanthropic. Rather, they do so because they realize that it's far easier to make money selling stock picks than it is to act upon them. If a few of their selections are dogs, they'll lose some subscribers, but replace them with a new batch enticed by the handful of "four baggers" they advertise on their website.

So when you read a well-reasoned critique of all that is wrong with mutual funds, do so carefully. If the critic follows up their litany of the industry's flaws with a suggestion that you subscribe to their stock-picking newsletter, buy an insurance-based investment, use their market-timing system, or purchase foreclosed real estate, know that you're being set up. Yes, the mutual fund industry has its flaws, but the answer to that problem is not to dive head-long into a half-baked strategy that you barely understand in the hopes of earning staggering returns. Rather, the answer should be to acknowledge that mutual funds can be the most efficient way to gain exposure to the stock and bond markets, and to resign to use them more effectively.