Mutual funds are one of the most popular investment vehicles for many investors. They come with many advantages, such as advanced portfolio management, risk reduction, and dividend reinvestment; however, there are many disadvantages to consider as well, such as high expense ratios and sales charges, tax inefficiencies, and possible management abuses. Before investing in one, read on to learn more details about the advantages and disadvantages of investing in mutual funds.
Key Takeaways
- Mutual funds are a popular investment choice in the U.S., allowing for investors to pool capital into a professionally managed investment vehicle.
- Investors have to pay fees for investing in mutual funds, which cover the costs of the fund doing business and the salaries of the professionals managing it.
- Mutual funds come with many advantages, such as advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing.
- Disadvantages include high fees, tax inefficiency, poor trade execution, and the potential for management abuses.
Mutual Funds: An Overview
Mutual funds pool together investments from shareholders to invest in securities, such as stocks, bonds, and other assets. There are a variety of funds covering different industries and different asset classes and they are managed by professional portfolio managers who seek to achieve capital gains for the fund's investors. Investors are charged various fees for the services that mutual funds provide.
When an investor invests in a mutual fund, they are seeking exposure to a variety of assets, do not have voting rights, and may be subject to certain rules, requirements, and certainly fees. Most mutual funds are managed and offered by large investment management companies, such as Vanguard and Fidelity.
Some of the advantages of mutual funds include advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing, while disadvantages include high expense ratios and sales charges, management abuses, tax inefficiency, and poor trade execution.
Advantages of Mutual Funds
There are many reasons why investors choose to invest in mutual funds with such frequency. Let's break down the details of a few.
Advanced Portfolio Management
When you buy a mutual fund, you pay a management fee as part of your expense ratio, which is used to hire a professional portfolio manager who buys and sells stocks, bonds, etc. This is a relatively small price to pay for getting professional help in the management of an investment portfolio.
Dividend Reinvestment
As dividends and other interest income sources are declared for the fund, they can be used to purchase additional shares in the mutual fund, therefore helping your investment grow.
Risk Reduction (Safety)
Reduced portfolio risk is achieved through the use of diversification, as most mutual funds will invest in anywhere from 50 to 200 different securities—depending on the focus. Numerous stock index mutual funds own 1,000 or more individual stock positions.
Convenience and Fair Pricing
Mutual funds are easy to buy and easy to understand. They typically have low minimum investments and they are traded only once per day at the closing net asset value (NAV). This eliminates price fluctuation throughout the day and various arbitrage opportunities that day traders practice.
As with any type of investment, the specifics of your budget, timeline, and profit goals will dictate what the best mutual fund options are for you.
Disadvantages of Mutual Funds
However, there are also disadvantages to being an investor in mutual funds. Here's a more detailed look at some of those concerns.
High Expense Ratios and Sales Charges
If you're not paying attention to mutual fund expense ratios and sales charges, they can get out of hand. Be very cautious when investing in funds with expense ratios higher than 1.50%, as they are considered to be on the higher cost end. Be wary of 12b-1 advertising fees and sales charges in general. There are several good fund companies out there that have no sales charges. Fees reduce overall investment returns.
Though similar to mutual funds, exchange-traded funds (ETFs) are a different type of investment vehicle, which are traded like stocks and generally come with lower costs and are easier to invest in.
Management Abuses
Churning, turnover, and window dressing may happen if your manager is abusing their authority. This includes unnecessary trading, excessive replacement, and selling the losers prior to quarter-end to fix the books.
Tax Inefficiency
Like it or not, investors do not have a choice when it comes to capital gains payouts in mutual funds. Due to the turnover, redemptions, gains, and losses in security holdings throughout the year, investors typically receive distributions from the fund that are an uncontrollable tax event.
Poor Trade Execution
If you place your mutual fund trade anytime before the cut-off time for same-day NAV, you'll receive the same closing price NAV for your buy or sell on the mutual fund. For investors looking for faster execution times, maybe because of short investment horizons, day trading, or timing the market, mutual funds provide a weak execution strategy.
Pros
Advanced portfolio management
Dividend reinvestment
Risk reduction
Convenience and fair pricing
Cons
High expense ratios and sales charges
Management abuses
Tax inefficiencies
Poor trade execution
What Are the Risks of Mutual Funds?
No investment is risk-free and while mutual funds are generally low-risk because they invest in low-risk securities, they are not completely risk-free. The securities held in a mutual fund may lose value either due to market conditions or to the performance of a specific security, such as the stock of a company if the company performs poorly. Other risks could be difficult to predict, such as risks from the management team or a change in policy regarding dividends and fees.
What Are Certain Advantages of Mutual Funds?
Mutual funds have plenty of advantages, including diversification, professional management, low costs, and convenience.
Are Mutual Funds Better Than Stocks?
Determining what is a better investment depends solely on the specific investor, their investment objectives, and their risk tolerance. Mutual funds allow for ease of access to a wide array of investments/companies, which increases diversification. They also carry lower risk because of that fact as opposed to investing in just a few stocks.
The Bottom Line
Mutual funds are a great way for investors to gain exposure to a wide variety of assets without having to specifically purchase investment securities one by one. They also allow an investor to leave the investment decisions up to a professional. While they can be a great and safe investment, they do not come without their flaws and issues.
Before investing, make sure to take your time researching the right mutual fund for you, being aware of the types of investments, risks, and costs associated with each particular fund you are considering and how they fit into your investment objectives.
