Why mutual funds can’t protect against a stock market crashArticle added by Roccy DeFrancesco on October 21, 2013
Roccy Defrancesco

Roccy DeFrancesco

MI

Joined: May 24, 2006

I recently saw that the stock market was crashing due in part to the government shutdown and the looming debt-ceiling extension, and I thought it was the perfect excuse to talk about how it’s nearly impossible to protect money from a crash if it’s invested in most mutual funds.

The fact of the matter is that most Americans use mutual funds for some part of their investment portfolio. This, of course, is because we have a broker-dealer-driven industry.

If you’ve been reading my recent articles, you know I’ve been trying very hard to change the discussion in our industry from using historical rate of return to investments to asking the following much more important question: What risks are you taking to achieve your expected rate of return?

Mutual funds stay invested in stocks, even when the market is crashing

Most investors don’t know that most mutual funds stay invested in stocks even when the stock market is crashing (and most advisors who sell mutual funds don’t seem to think about the ramifications).

Don’t believe me? Go to www.finance.yahoo.com and look up the symbols of two of the more popular mutual funds. On the profile page, you can find the percentage (%) of how much each fund is invested in the market. I’ve listed it for these two funds.
    -FBGRX (Fidelity Blue Chip Growth)                                80 percent invested

    -AEPGX (American Funds EuroPacific Gr A)                                80 percent invested
The by-product of being invested in the market with 80 percent of the fund’s assets is that when the stock market crashes, so does the mutual fund. In other words, the fund managers will not go to 50 percent, 75 percent, or 100 percent cash, even if they know the stock market is crashing. It’s proven true by the numbers. Look how each of the above funds did during the crash years of 2008, 2002, 2001, and 2000:
    -FBGRX: 2008 = -38.60%; 2002 = -25.32%; 2001 = -16.55%; 2000 = -10.54% Total losses = -91.01%

    -AEPGX: 2008 = -40.53%; 2002 = -13.61%; 2001 = -12.17%; 2000 = -17.84% Total losses = -84.15%
It’s crazy to think that these and many other mutual funds would stay invested in the market when it’s crashing, but that’s the reality — a reality that most clients are unaware of.

Because the mutual funds themselves do not protect clients when the market is crashing, who does that leave to protect the client? The local financial planner. Is it realistic for a local advisor to recommend that clients go to all cash? That would be nice, but most think they already did their job by picking the “best” mutual funds.
Using tactically managed strategies

How would your clients have liked the following returns during the crash years?
    2008 = +8.03%; 2002 = +7.04%; 2001 = +7.55%; 2000 = +2.07% Total returns in crash years = +24.69%
These returns look a lot better than the negative returns of the above-listed mutual funds. Would it help you to know that the tactically managed strategy with the above listed returns has not had a down year in the last 21 years and has had an average net rate of return in excess of 9 percent?

If this article doesn’t make you wonder if mutual funds are the best place for your client’s money and consider learning about truly tactically managed strategies, then I have failed.

Alternatives to mutual funds

What are the logical alternatives to growing wealth with mutual funds?

1. Tactically managed investment strategies — These are strategies that are managed to limit downside risk and capture gains in up markets. One of my favorite managers has a 21-year audited track record of no down years and net returns in excess of 9 percent. So, for the money a client should have “in the market,” being in a tactically managed strategy is the way to go.

2. Equity indexed universal life insurance (EIUL) — As many of you know, this is one of my favorite wealth-building tools for clients under the age of 55. Gains are locked in, no downside risk due to negative markets, tax-free loans, etc.

3. Fixed indexed annuities (FIAs) — I don’t like to say FIAs are a replacement for a market driven portfolio; it’s comparing apples to oranges. However, especially for clients 55 and old, using an FIA (especially those with guaranteed income riders) can be a much more prudent decision than using what most financial planners would recommend — an asset allocated portfolio.

Bottom line

Mutual funds will not protect your clients’ money during stock market crashes. They need to know this so they can make informed decisions about whether to use them or whether they should seek out other tools to grow their wealth in a truly protected manner.
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