Thanks for the question. Here are a few things to consider.
- Instant diversification: A mutual fund will provide you with a "basket of stocks" that will provide diversification in your portfolio.
- Effective for smaller accounts: Since a mutual fund provides exposure to hundreds or thousands of stocks, you don't need to go out and buy hundreds or thousands of stocks on your own, which could be very prohibitive for you if you have a smaller-sized investment account and limited capital to invest with.
- Professional money management: Mutual funds are run by investment managers who would likely be considered "experts" in their field. Mutual fund companies have resources that are above and beyond what one may have as an individual, retail investor.
- No intraday-trading on mutual funds: If you want to make a trade on your mutual fund, you'll likely not know what the "NAV" price will be when you lock in the trade. That is because the NAV (Net Asset Value) is settled at the end of each trading day. If you don't lock your trade in before the end of the stock market close, you'll receive the NAV as of the close of business the following day. This makes it difficult and/or impossible to capitalize on sudden movements in the market (if that is something you're trying to do).
- Not tax-efficient: In a non IRA account, mutual funds will process capital gain distributions about once per year, which you will then be taxed on, even if you did not take any capital gains that year. The end investor has little impact or say on how much a fund will decide to spit out in capital gain distributions. The funds have the freedom to delay capital gain distributions in some years, essentially kicking the can down the road for later years. This could adversely impact you as the end investor.
- Subject to the herd: If you are a disciplined investor and you know not to "buy high" and "sell low," then you won't panic when volatility occurs in the marketplace. However, when investing in a large mutual fund, chances are that many of your fellow investors will not have the same discipline. They will sell at a low point, causing the fund to sell positions in order to account for the redemption requests. In other words, your performance may suffer because of the lack of discipline of other investors that also own the same fund.
- Impersonal connection: When investing in a mutual fund, you do not usually have easy access to the one making the investment decisions. There may be quarterly investor calls and updates, but there will be a significant lack of interpersonal communication with the main folks in charge of the fund.
- Costs: Mutual funds always carry some kind of costs. In all cases, costs will decrease your overall rate of return. That is why it is important to limit the annual expenses of mutual funds, the potential front-end or back-end loads, and turnover costs. It takes more than a novice investor to navigate these issues, but this is one of the most important downsides to using mutual funds and thus, should certainly be evaluated and address by all investors.
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Joe Allaria, CFP®
Mutual funds are currently the most popular investment vehicle and provide several advantages to investors, including the following:
- Advanced Portfolio Management
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 help in the management of an investment portfolio.
- Dividend Reinvestment
As dividends and other interest income is declared for the fund, it can be used to purchase additional shares in the mutual fund, thus helping your investment grow.
- Risk Reduction (Safety)
A 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 their focus. Several index stock mutual funds own 1,000 or more individual stock positions.
- Convenience and Fair Pricing
Mutual funds are common and easy to buy. They typically have low minimum investments (some around $2,500) 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.
However, there are also disadvantages of mutual funds, such as the following:
- 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 1.20%, as they will be considered on the higher cost end. Be weary 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.
- Management Abuses
Churning, turnover and window dressing may happen if your manager is abusing his or her 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 gain 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.
Some advantages to an active mutual fund is its built-in diversification, daily liquidity, professional management, regulatory oversight, net performance reporting and ease of comparison.
Some disadvantages of an active mutual fund are its higher cost vs passive ETF's or index products, potential for annual capital gains distributions and the non-guaranteed returns.
The advantage of a mutual fund is that you can invest a limited amount of money and get a diversified portfolio. You can do this in one general fund, or build a portfolio of different funds of various asset classes. Over time this can improve your return and smooth out the volatility.
The disadvantages of a fund are that you are part of a crowd that owns shares of the fund, but don't really own the underlying securities. Why does that matter? When the market has a problem, investors often panic and sell shares when the manager of the fund might see a buying opportunity. But instead he has to sell into the bad market to raise money for those who want out. This can hurt performance and worse yet, the fund could sell shares at a profit, so your return in the fund could be negative but you may still have to pay capital gains!! This is a big issue and should be noted.
When the first ETF (Exchange-Traded Fund) debuted in 1993 and subsequently flourished into today’s choice for many people’s investment, mutual funds may suddenly look like unloved & ready be shelved. But, don’t, for mutual funds still have many advantages.
For one thing, it’s cheaper to do the auto investing (dollar-cost averaging) with mutual funds. Secondly, certain mutual funds have one fund that covers all, from equities to fixed income, such as a balanced-fund; whereas ETF does not have such option at the present time. Therefore, instead of having one fund in a start-up investment as in the case for young people, you have to have two ETF funds for the portfolio.
On the other hand, ETFs track indexes, on average, cost less than mutual funds, but the biggest advantage of ETF is its flexible trading option. Unlike mutual funds, you can only make one trade. With ETF, you can trade throughout the day, which gives you the option to get in or out if you see the opportunity for your intended purchase. I do want to caution on people not to turn this advantage into a disadvantage & become a day trader. Lastly, you can set up limit & stop orders with ETF, but you can’t do that with mutual funds.
Happy learning and investing!