What are the advantages and disadvantages of mutual funds?

By Steven Merkel AAA
A:

Mutual funds are currently the most popular investment vehicle and provide several advantages to investors, including the following:

  1. 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.

  2. 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.

  3. 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.

  4. 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:

  1. 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.

  2. 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.

  3. 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.

  4. 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.

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Watch: Mutual Funds

For additional reading, take a look at Stop Paying High Mutual Fund Fees and Analyzing Mutual Fund Risk.

This question was answered by Steven Merkel.

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