Stock Market Tips – Are Mutual Funds Really Mutually Beneficial?

Mutual funds are one of the most popular investment vehicles in America.  So popular that there are well over 10,000 available to choose from!  Most articles focus on picking a fund but I’m going to ask a completely different question. Are the benefits of mutual funds mutually beneficial?

What is a fund?

To start let’s define what a mutual fund is for those readers who may be a little unsure.  A mutual fund is an account (called a fund) where many people pool their money for the purpose of investing. Imagine you want to buy a McDonald’s franchise.  However the cost of opening this store is going to be almost $2 million.  You do not have that much money so you look for partners.  Eventually there are 5 partners, each splitting the $2 million startup investment.  Then 4 years later the 5 of you decide to sell.  You sell the complete business for $10 million and divide the profits 5 ways.  That would be a partnership.  And yet it’s also a good  picture of how a mutual fund works.

A mutual fund is a bunch of people who become small partners.  They pay in their investment and then someone else runs the business – in this case a stock portfolio.  However there are some partners who don’t pay in.  In fact they get paid to not pay in.  They are the fund managers and all the people involved in the business.  And that’s where the mutual benefits break down. 

The inequality comes in the form of SEC rules.  According to SEC rules a mutual fund can only buy stock, hold it, and sell it later.   That means a mutual fund can only make money when the stock market goes higher.  The plan of the fund manager is to buy low, and sell high.  Unfortunately the stock market does not always go up (just look at the October 2008 market crash).  So inevitably the fund’s value will go up and down.  At the end of the year investors are hoping generally for an annual return, or growth, of about 15-20%. 

This description may not sound bad to you.  That’s because you have probably adjusted to this treatment and assume it is “the rules of the game”.  After all this is how you have been programmed to respond.  But what you may not know is what happens behind the scenes. 

It may not be legal for a mutual fund to trade your MONEY during a down market, but they CAN trade the fund’s assets.  And they do.  And they make bank.  In fact the trading behavior of institutional investors is so predictable an entire segment of stock market analysts spend their time watching behavior of institutions and trading off of that behavior. 

What Are They Doing With Your Money?

So what exactly are they doing with your stocks?  Most they are doing one of two things.  They are:

Lending your stocks to Short Sellers.   When an institution has a fund full of stock shares those shares are available to be lent out.  And believe me, they do.  When it looks like a stock is going down they lend your stock to people who want to sell it without owning it.  These people are known as short sellers.  When they lend these stocks you know of course they make profit.  In and of itself lending stock to short sellers is not a problem.  The unfair part is the fact that the institution alone, and not the fund investors, benefit from this little dealing.  So the fund manager is lending your stock, and making money, while you sit at home wondering why your portfolio is getting smaller and smaller.

Write Options against it.  The second thing funds may do is to write options against your stock.  They really don’t even care how it pans out.  Worst case scenario for the fund is they sell your stock for less than they meant. So long as the people make a little profit the fund doesn’t care if the people don’t make as much as they could.  And what about the option?  Well they make money on that too.  Usually 10-20% per month.  That’s right, you are settling for 20% each year, while the people managing your mutual fund are making 20% each month with the stock you bought. Again, the practice they are doing is fine – but it’s not fair that they make the money and do not share in the profit.

There is however a way you can profit from the same tricks traditionally held for fund managers.  You simply learn the same strategies and techniques and do them on your own, without a fund manager.  Not only are these strategies legal, they are done every day by millions of Americans.  The difference in you and them is simply a little education.