Good, bad and ugly of mutual funds

Given the restrictions we have on picking Halal individual stocks, mutual funds come to our rescue. However, not all is well with them.

First, mutual funds are good in that you don't have to pick stocks and/or rebalance. Mutual fund manager does it for you. So, it's a hands-off approach for investment. They tend to emulate overall market performance, albeit not upto the mark because of the fees involved. Which brings me to the bad side of mutual funds

Mutual funds are bad in the sense they carry anywhere between 1.5-0.5% annual fee for managing. This does not seem much on paper, but over the long period this will have significant impact on your returns. Also, fee is not directly related to performance. As a mutual fund buyer, you have no say in fee amount. You either buy it or you don't. Another bad part of the mutual fund is it's price. It's price is published 2-3 hours after the market closes each business day but you have to place orders before the close of that business day. So, you won't exactly know how much it would cost until you buy it. This is bad because let's say you decide to sell mutual fund, there is no guarantee in the price you are gonna sell. In contrast, you always have control for the sell/buy price of a stock.

Get ready for surpise taxes of mutual funds

The ugly part of mutual funds is that if you hold them in taxable accounts (non-401k, non-retirement accounts etc), you get slapped with taxes even if you don't earn any profit. To explain this further, let's say you decide to invest in mutual funds one fine day when your plan to buy a home fell through. So, you buy some 1000 units of Halal mutual fund on Dec 16th with Net Asset Value (NAV) of $10. Assume, by Dec 31st, mutual fund didn't change much (NAV of $10), leaving you with neither profit nor loss. But Uncle Sam has a weird rule which says all mutual funds should distribute their losses/gains for that year to the individual investor.

Most mutual funds do it at the end of the year, some do it twice/year. Although you bought it at NAV $10, the mutual fund might have had NAV of $8 at the beginning of the year,accumulated capital gains and dividends over the course of the year and reached to NAV $10 on Dec 31st. Mutual fund distributes $10-$8=$2 to each individual on Dec 31st. So, for Uncle Sam you have to pay taxes on the 1000*$2 profit you 'achieved'. Basically you have to pay taxes on the amount you did not make. Although this sounds cruel, there is some respite to this madness. On Dec 31st, NAV would fall down to $8 from $10 since $2 was 'distributed'. You will still have 1000 units of the same mutual fund and 1000*$2 = $2000 cash. Now, if the market is bullish, let's say by Feb the NAV reached to $10 again. If you decide to sell in Feb, you will now have 1000*$10 = $10,000 and $2000 cash from Dec 31st distribution. So total of $12000. But to Uncle Sam, your profit is now zero because your cost basis (avg price you paid) is $10 and your sell price is $10.

Therefore, for mutual funds, you will end up paying taxes in advance if you hold them in taxable accounts. You can check individual mutual fund website or prospectus for distribution dates so that you don't end up buying them for taxes.

You can find list of Halal mutual funds here

#MutualFunds