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Island Investing

Riffs, rants, and the upside of investing from way off Wall Street


How Mutual Funds Are Like Swimming Pools

Swimming pools are great fun. But which do you prefer: a private pool or a public one?

Most folks will choose the private pool. The big problem with the public pool, after all, is the behavior of the other swimmers. They do cannonballs when you’re trying to do laps. Their kids are screaming, splashing, and, well, peeing while you try to relax. And – there is no delicate way to say this – some of those people just shouldn’t be wearing bathing suits.

The same goes for mutual funds.

Mutual funds are public pools of money. Mutual fund managers will accept anyone into the pool. And just like the other swimmers at a public pool, fellow shareholders can spoil a good thing.

Consider how a temporary market downturn (aren’t they all?) affects even the best mutual fund portfolio manager. Assume the manager foresaw the downturn, but made no changes in the fund since he believed he had a solid, well-constructed portfolio that would provide his investors good long-term returns.

This is a good thing.

But his investors may not trust him, or they may have their own dire market outlook. So, they start selling shares to move to something they consider safe. To give these selling shareholders their money, the manager has to sell holdings he believes are long term winners. That means not only will that fund manager be selling when he should be buying, but if the departing shareholders are large institutions, the act of selling could depress the prices of those stocks still in the fund.

In other words, while you were a good and patient investor who believed in the long-term growth of the portfolio, your holdings could effectively be sold out from under you by your fellow shareholders.

Unfortunately, it doesn’t stop there. A tax bill may be due on the stocks the manager had to sell, too.

Now, the selling shareholders don’t pay those taxes. And the mutual fund doesn’t pro-rate the taxes to shareholders who owned the fund earlier that year.

So who pays?

You got it.

Those taxes are passed onto the smart, patient, well-meaning investors who are still shareholders of the fund at year end.

So not only does a mutual fund investor get hurt when his fellow swimmers panic, he gets stuck with the bill, too.

What’s that all mean?

It’s time for a private pool.

Welcome to the world of Spoke Funds®.