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  • In a chapter of “Millionaire Teacher” by Andrew Hallam, a schoolteacher who built a $1 million portfolio, Hallam spells out his opposition to actively-managed mutual funds.
  • He explains that he invests in low-cost index funds instead, since they offer consistent returns and cost very little to own.
  • Mutual funds, on the other hand, may beat the average market return in theory, but once you factor in costs, you’re losing out compared to index funds.
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For a long time, the reason I didn’t invest in mutual funds was because my income never felt high enough — and because I wouldn’t have known the first thing about where to start. But even as I’ve become more knowledgeable and been able to sock away savings and start to invest, I haven’t changed my tack. 

It’s a fact that has much to do with a book by Andrew Hallam, a schoolteacher who built a $1 million investment portfolio, called “Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School.” The rule that governs Chapter 3 is “Small Fees Pack Big Punches,” and reading it left me with a healthy skepticism of actively-managed mutual funds — and the financial advisors who push them — that lingers to this day.

The difference between index funds and mutual funds

To illustrate his point, Hallam pits the glossy mutual fund against the humble low-fee index fund, an unsexy slice of the overall market that offers broad exposure and an average annual return that hovers around 10%. While there are plenty of mutual funds that beat both that average and the S&P 500 year after year, Hallam encourages his reader to zoom in further to discover just how rare — and misleading — such a feat truly is. 

If financial advisors worked on a volunteer basis and mutual funds were free to run, he notes, they’d triumph over index funds about half the time. (Because index funds, being representative of the market at large, can never actually beat that market, which individual stocks and funds can.) But until that fantasy becomes a reality, Hallam estimates that an actively-managed mutual fund will need to beat the S&P 500 by an average of 4.6% just to break even. 

What mutual fund investors may be paying for without knowing it

That amount is tallied from a slew of hidden taxes, trading costs, and fees, and breaks down as follows, with each number representing a percentage of your total assets:

  1. Expense ratios: These are hidden costs to run the fund that go toward paying analysts, traders, and owners, plus general overhead. Typically around 1.5% of your total assets.
  2. 12B1 fees: Marketing expenses to help reel in new investors, which Hallam estimates are charged by about 60% of funds and can run up to 0.25%. 
  3. Trading costs: The “actively-managed” part of actively-managed mutual funds means your money manager is buying and selling stocks, and those transactions come at a cost: around 0.2% annually.
  4. Sales commissions and load fees: Baked-in costs to buy or sell loaded funds. These go straight to your salesperson, and can be up to 6% of your total assets.
  5. Taxes: The majority of mutual funds are taxable, with the government dinging you for any realized capital gains. The more you trade, the less tax-efficient the account becomes, giving low-trading index funds a post-tax advantage.
  6. Wrap fee/advisor fee/account fee: These are sneaky little fees that can get slipped in under the radar, and total up to 1.75%. 

Each charge represents what may feel like a tiny fraction of your total holdings. But as Hallam points out, they add up quickly, stacking up towering odds against an actively-managed mutual fund ever beating a low-fee index fund.

Why some financial advisors sell mutual funds anyway

Hallam quotes a whole host of financial experts, Nobel-prize winning economists, and some of the richest people on the planet to substantiate his claims, but one group of folks is notably absent: financial advisors. Hallam notes that despite what math and historical precedence tell us about the odds, many financial advisors are unlikely to recommend index funds to their clients.

That’s because every time they do, they’re missing out on all the fees outlined above. There isn’t much to do with index funds except hold them long term, which does little to pay your money manager’s bills. 

If you happen to be working with a financial advisor who touts index funds for their clients, hold onto them with both hands. Because that’s someone who’s working for you and your money instead of their own bottom line. But if you’re being nudged toward actively-managed mutual funds, Hallam recommends taking that advice with a healthy dose of skepticism — and I’m inclined to agree with him.

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