One advantage that a mutual fund has over a particular stock is definitely diversification. In the stock investing world, company stocks are sold individually. This means that if you want to keep yourself diversified across several different industries or sectors, you will have to be responsible for managing an investment portfolio (keeping track of which stocks to keep and which ones to let go of). Unless you have a very specific idea of the types of stocks you are interested in buying, assembling your own stock portfolio can be a very time-consuming task and I have found that the more some people have to keep track of, the more difficult and stressful it becomes.
With a mutual fund, you're diversified by owning a security that has a piece of several different companies that can sometimes range from several different sectors (depending on which type of mutual fund you buy). In this scenario, the appropriate investment choices will be made by the mutual fund's manager, so your job becomes less of managing the portfolio but rather managing the managers, so to speak, by selecting which mutual funds to own.
The disadvantage to a mutual fund in this very same scenario could actually be the money manager. Because mutual funds are groupings of securities or investments, they tend to have a lot of moving parts. Those moving parts can sometimes come with very high fees. It can be tough to track exactly which fees are being charged, let alone exactly how much is coming out of your account based on standard fees like; 12b1 fees, portfolio marketing fees, trading fees and portfolio turnover costs. The unfortunate thing is that the fund expenses are usually just the tip of the iceberg when it comes to mutual fund fees. There are also money management fees on top of your fund expenses as well and can be charged in a variety of ways from an upfront sales charge (or load), to an annual commission based charge as well. Some of these fees are changed by the fund manager and some can also be charged as commissions which are paid to your investment broker (if you buy the funds from one).
For more detailed description of the costs associated with mutual funds, I would check out this great article here on Investopedia: http://www.investopedia.com/university/mutualfunds/mutualfunds2.asp.
My recommendation for an investor looking to decide whether they should be buying mutual funds or stocks would be to think about your financial situation and how you would feel if you had to pay someone to manage your money. For those that would take more of a do-it-yourself type path and feel comfortable managing their own investments, a do-it-yourself stock portfolio may be the right choice for you. For those that would rather manage the managers, not have to make day-to-day investment decisions and trust in more of a passive investment strategy, then mutual funds may be a great choice for you. It may be worth spending a little bit of extra money so you can get back to doing the things that are really important to you if you want to invest but would like to keep more of a hands-off approach with your money on a day-to-day basis.
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.
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.
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®