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.)
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.)
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".
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.
Mutual Funds & ETFsPlanning for retirement in this economic and investment environment is far from easy. American Funds might offer an answer.
Mutual Funds & ETFsLearn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
Mutual Funds & ETFsLearn about the difference between using mutual funds versus ETFs for retirement, including which investment strategies and goals are best served by each.
Mutual Funds & ETFsLearn 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.
Mutual Funds & ETFsDiscover the top Vanguard target-date retirement funds with target dates in 2020, 2030 and 2050, and learn about the characteristics of these funds.
Mutual Funds & ETFsDiscover the three Vanguard funds tracking the S&P 500 Index, and learn about the characteristics and historical statistics of these funds.
InvestingReal estate investment trusts offer a unique way for investors to own a real estate portfolio without the risks of owning single properties.
Mutual Funds & ETFsLearn 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.
Financial AdvisorsTarget date funds have grown in popularity as an investment of choice among 401(k) investors. Here's a closer look at Vanguard's offerings.
Mutual Funds & ETFsLearn how to buy mutual funds online; discover which websites offer mutual fund trading services, how to choose a fund and typical fees.
The Federal Deposit Insurance Corporation (FDIC) works as a protector for customers when banks and financial institutions ... Read Full Answer >>
The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
When a third party gains access to your bank account and conducts transactions without your consent, the FDIC does not have ... Read Full Answer >>
The Federal Deposit Insurance Corporation (FDIC) does not cover credit unions. The FDIC only insures deposits in banks and ... Read Full Answer >>
Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
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 >>