Like many investments, mutual funds offer advantages and disadvantages, which are important for you to consider and understand before you decide to buy. Here we explore some of the drawbacks of mutual funds. (For some of the benefits, see The Advantages of Mutual Funds.)

Fluctuating Returns
Mutual funds are like many other investments without a guaranteed return: there is always the possibility that the value of your mutual fund will depreciate. Unlike fixed-income products, such as bonds and Treasury bills, mutual funds experience price fluctuations along with the stocks that make up the fund. When deciding on a particular fund to buy, you need to research the risks involved - just because a professional manager is looking after the fund, that doesn\'t mean the performance will be stellar.

Another important thing to know is that mutual funds are not guaranteed by the U.S. government, so in the case of dissolution, you won\'t get anything back. This is especially important for investors in money market funds. Unlike a bank deposit, a mutual fund will not be insured by the Federal Deposit Insurance Corporation (FDIC). (For more on this, read Are My Investments Insured Against Loss?)

Although diversification is one of the keys to successful investing, many mutual fund investors tend to overdiversify. The idea of diversification is to reduce the risks associated with holding a single security; overdiversification (also known as diworsification) occurs when investors acquire many funds that are highly related and, as a result, don\'t get the risk reducing benefits of diversification. (To read more on this subject, see The Dangers Of Over-Diversificaton.)

At the other extreme, just because you own mutual funds doesn\'t mean you are automatically diversified. For example, a fund that invests only in a particular industry or region is still relatively risky.

Cash, Cash and More Cash
As you know already, mutual funds pool money from thousands of investors, so everyday investors are putting money into the fund as well as withdrawing investments. To maintain liquidity and the capacity to accommodate withdrawals, funds typically have to keep a large portion of their portfolios as cash. Having ample cash is great for liquidity, but money sitting around as cash is not working for you and thus is not very advantageous.

Mutual funds provide investors with professional management, but it comes at a cost. Funds will typically have a range of different fees that reduce the overall payout. In mutual funds, the fees are classified into two categories: shareholder fees and annual operating fees.

The shareholder fees, in the forms of loads and redemption fees, are paid directly by shareholders purchasing or selling the funds. The annual fund operating fees are charged as an annual percentage - usually ranging from 1-3%. These fees are assessed to mutual fund investors regardless of the performance of the fund. As you can imagine, in years when the fund doesn\'t make money, these fees only magnify losses. (For more on this topic, read Stop Paying High Fees.)

Misleading Advertisements
The misleading advertisements of different funds can guide investors down the wrong path. Some funds may be incorrectly labeled as growth funds, while others are classified as small cap or income funds. The Securities and Exchange Commission (SEC) requires that funds have at least 80% of assets in the particular type of investment implied in their names. How the remaining assets are invested is up to the fund manager.

However, the different categories that qualify for the required 80% of the assets may be vague and wide-ranging. A fund can therefore manipulate prospective investors by using names that are attractive and misleading. Instead of labeling itself a small cap, a fund may be sold as a "growth fund". Or, the "Congo High-Tech Fund" could be sold with the title "International High-Tech Fund".

Evaluating Funds
Another disadvantage of mutual funds is the difficulty they pose for investors interested in researching and evaluating the different funds. Unlike stocks, mutual funds do not offer investors the opportunity to compare the P/E ratio, sales growth, earnings per share, etc. A mutual fund\'s net asset value gives investors the total value of the fund\'s portfolio less liabilities, but how do you know if one fund is better than another?

Furthermore, advertisements, rankings and ratings issued by fund companies only describe past performance. Always note that mutual fund descriptions/advertisements always include the tagline "past results are not indicative of future returns". Be sure not to pick funds only because they have performed well in the past - yesterday\'s big winners may be today\'s big losers. (To learn more, read Choosing Quality Mutual Funds.)

When you buy any investment, it\'s important to understand both the good and bad points. If the advantages that the investment offers outweigh its disadvantages, it\'s quite possible that mutual funds are something to consider. Whether you decide in favor or against mutual funds, the probability of a successful portfolio increases dramatically when you do your homework.

Related Articles
  1. Mutual Funds & ETFs

    American Funds' Top Funds for Retirement

    Planning for retirement in this economic and investment environment is far from easy. American Funds might offer an answer.
  2. Mutual Funds & ETFs

    Buying Vanguard Mutual Funds Vs. ETFs

    Learn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
  3. Mutual Funds & ETFs

    ETFs Vs. Mutual Funds: Choosing For Your Retirement

    Learn about the difference between using mutual funds versus ETFs for retirement, including which investment strategies and goals are best served by each.
  4. Mutual Funds & ETFs

    The 8 Most Popular Vanguard Funds for a 401(k)

    Learn about some of the mutual funds in Vanguard's lineup that are popular among 401(k) investors, and find out why you should consider them.
  5. Mutual Funds & ETFs

    Best 3 Vanguard Mutual Funds for Retirement

    Discover the top Vanguard target-date retirement funds with target dates in 2020, 2030 and 2050, and learn about the characteristics of these funds.
  6. Mutual Funds & ETFs

    Best 3 Vanguard Funds that Track the Top 500 Companies

    Discover the three Vanguard funds tracking the S&P 500 Index, and learn about the characteristics and historical statistics of these funds.
  7. Investing

    What Is a REIT and Does It Belong in My Portfolio?

    Real estate investment trusts offer a unique way for investors to own a real estate portfolio without the risks of owning single properties.
  8. Mutual Funds & ETFs

    The 3 Best Vanguard Mutual Funds for Your Roth IRA

    Learn about Vanguard funds that are good choices for a Roth IRA. Read about how Vanguard funds make it easy for investors to diversify their portfolios.
  9. Financial Advisors

    Vanguard's Target Date Funds: What You Should Know

    Target date funds have grown in popularity as an investment of choice among 401(k) investors. Here's a closer look at Vanguard's offerings.
  10. Mutual Funds & ETFs

    Looking to Buy Mutual Funds Online? Here Is How

    Learn how to buy mutual funds online; discover which websites offer mutual fund trading services, how to choose a fund and typical fees.
  1. Are 401ks FDIC insured?

    The Federal Deposit Insurance Corporation (FDIC) works as a protector for customers when banks and financial institutions ... Read Full Answer >>
  2. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  3. Does the FDIC cover identity theft?

    When a third party gains access to your bank account and conducts transactions without your consent, the FDIC does not have ... Read Full Answer >>
  4. Does the FDIC cover credit unions?

    The Federal Deposit Insurance Corporation (FDIC) does not cover credit unions. The FDIC only insures deposits in banks and ... Read Full Answer >>
  5. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  6. Does OptionsHouse have mutual funds?

    OptionsHouse has access to some mutual funds, but it depends on the fund in which the investor is looking to buy shares. ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  2. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  3. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  4. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  5. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  6. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
Trading Center