For the firms operating the nation’s leading mutual funds, times are tough and getting tougher. If you have money parked in their key funds, then be prepared to be dragged along for the ride. Net results are weak and could get even weaker, making this a bad time to commit new money to traditional mutual funds.

A one-two blow
For several decades, mutual funds have looked like a bad idea — at least when compared with index funds. Many top funds have done alright in terms of stock-picking, but the high level of management fees and sales expenses have rendered them uncompetitive against a traditional index fund such as Vanguard’s S&P 500 Index fund (Nasdaq: VFINX), which carries just 0.17% in annual expenses. Compare it with a popular mutual fund such as the Legg Mason Capital Management Value Fund (Nasdaq: LMVTX), which carries a sales load of 0.95% and an annual expense fee of 1.76%.

It’s bad enough that these expenses will take a steadily rising bite throughout many years, but  performance can be weak as well — the Legg Mason fund has lost an average of 2% in the past 10 years, according to Morningstar.

But index funds are the least of these funds’ troubles. Exchange-traded funds (ETFs) are starting to look like a wiser bet as well. Like index funds, these ETFs carry low expenses and allow for much more targeted investments. If you’re bullish on copper, then you can simply buy a low-cost copper-focused ETF like First Trust ISE Global Copper Index (NYSE: CU) instead of a broad-based commodity fund offered by the mutual fund firms.

The redemption curse
Investors have now realized the relative weaknesses of the mutual-fund approach (especially those focused on stocks rather than bonds), so they’ve been pulling money out at a steady pace. As fund managers get the word to raise cash to meet client redemptions, they have to find stocks to sell. And as they do that, they hurt the prices of the very equities they own. Of course, the converse is also true. Mutual funds can generate great results when they receive fresh client funds because they can load up even deeper on key stocks. This is why the tech-focused mutual funds did so well in the late 1990s — everyone wanted a piece. Many funds poured money into Cisco Systems (Nasdaq: CSCO), Dell (Nasdaq: DELL) and others, sending these stocks even higher. However, with the advent of ETFs and the ongoing popularity of index funds, it’s not clear whether we’ll ever see such a positive flow into mutual funds ever again.

Forget about the past
Investors may also be souring on mutual funds after realizing it’s almost impossible to outperform the market for a long period. Bill Miller was able to do it at the Legg Mason Capital Management Value Fund from 1991 through 2005 — a feat that’s virtually unparalleled in the modern era. But Miller’s fund has trailed the S&P 500 in four of the past five years.

As another example, Fidelity, one of the nation’s top fund firms, has always sought to place its sharpest managers at the helm of its flagship Fidelity Magellan Fund (Nasdaq: FMAGX). The firm was able to to beat the indexes throughout much of the 1980s and 1990s, thanks to Peter Lynch. But if you invested in Magellan at the start of 2006, then your money’s performance would be virtually flat. The S&P 500 would have at least gained 12% in that time.

Action to Take –> The mutual fund industry is at a crossroads. If you own existing funds (and they carry reasonable expenses), then there’s no reason to rush out and dump them. But these funds should no longer be a magnet for your new investment dollars. Until the fund industry solves the perennial problem of high expenses and poor performance, index funds and ETFs are the better bet for your money.

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