Margin-of-Safety

Investment Alternatives for the Individual Investor 223 Mutual Funds
Mutual funds are, in theory, an attractive alternative for the individual investor, combining
professional management, low transaction costs, immediate liquidity, and reasonable diversification.
In practice, they mostly do a mediocre job of managing money. There are, however, a few
exceptions to this rule.
For one thing, investors should certainly prefer no-load over load funds; the latter charge a
sizable up-front fee, which is used to pay commissions to salespeople. Unlike closed-end funds,
which have a fixed number of shares that fluctuate in price according to supply and demand,
open-end funds issue new shares and redeem shares in response to investor interest. The share
price of open-end funds is always equal to net asset value, which is based on the current market
prices of the underlying holdings. Because of the redemption feature that ensures both liquidity
and the ability to realize current net asset value, open-end funds are generally more attractive for
investors than closed-end funds. 1
Unfortunately for their shareholders, because open-end mutual funds attract and lose
assets in accordance with recent results, many fund managers are participants in the short-term
relative-performance derby. Like other institutional investors, mutual fund organizations profit
from management fees charged as a percentage of the assets under management; their fees are not
based directly on results. Consequently, the fear of asset outflows resulting from poor relative
performance generates considerable pressure to go along with the investment crowd.
Another problem is that open-end mutual funds have in recent years attracted (and even
encouraged) "hot" money from speculators looking to earn quick profits without the risk or bother
of direct stock ownership. Many highly specialized mutual funds (e.g., biotechnology,
environmental, Third World)