What are the advantages and disadvantages of mutual funds?
That is a great question. Almost, if not, all investments will have both pros and cons associated with them.
A mutual fund by definition is a company that pools money from many investors that can invest in many vehicles, including stocks, bonds, short term debt, and alternative investments. Investors buy shares in a mutual funds and each share represents the investor’s part ownership in the fund, any appreciation or depreciation and the income it generates.
I have highlighted some of the major advantages and disadvantages below.
Diversification: “Don’t put all your eggs in one basket” - A single mutual fund can hold a wide range of securities from different issuing companies. ”Focus” funds are on the lower end of the spectrum and can hold little as twenty investments that the manager has high conviction in. On the other hand, there are mutual funds that hold thousands upon thousands of different investments. Generally a mutual fund will often have somewhere between 75-125 holdings. This diversification may considerably reduce the risk of a serious monetary loss due a particular company or industry having “bad” or negative returns.
Affordability: Many mutual funds set a relatively low dollar amount for initial investment and subsequent purchases. For example, many fund families allow you to begin buying units or shares with a small dollar amount (example being $500) for the initial purchase. Some mutual funds also permit you to buy more units on a regular basis with even smaller installments (example being $50 per month) allowing small dollar amounts to invest in many companies/issues. This allows an individual to own all of the underlying investments of the fund that may not have been affordable to purchase each holding individually.
Professional Management: Many investors do not have the time or expertise to manage their personal investments every day, to efficiently reinvest interest or dividend income, or to filter through the thousands of securities available in the financial markets. Mutual funds are managed by professionals who are experienced in investing money and who have the education, skills, and resources to research diverse investment opportunities. Not only with they do the security selection, but many will also monitor performance, and make adjustments with the changing economic and market cycles.
Liquidity: Units or shares in a mutual fund can be bought and sold any business day (that the market is open), providing investors with easy access to their money for the current Net Asset Value (NAV) minus any redemption fees, usually within three business days of the transaction.
Flexibility: Many mutual fund companies manage several different funds (e.g., money market, fixed-income, growth, balanced, sector, index, international, global, alternative, allocation, target date and hedging strategies) and allow you to switch between these funds at little or no charge. This enables you to change your portfolio balance as and when your personal needs, financial goals or market conditions change.
When you invest in a mutual fund you place your money in the hands of a professional manager. The return on your investment depends heavily on that manager’s skill and judgment and the way they decide to invest your money. Not every manager has the same resources, depth of research/analyst teams, or experience backing their decisions. There are also multiple investment philosophies that are widely accepted in the financial industry and it’s up to the manager to decide which one they think is best.
Research has shown that few portfolio managers are able to consistently out-perform the market over long periods of time (according to a 2016 study done by Kent Smetters, professor of business economics at Wharton). It’s a good idea to look at the fund manager’s track record for 1, 3, 5, 10 year and/or since the mutual fund’s inception. It is also important to try and uncover the “why” behind that fund’s performance and decide if the performance is both sustainable & replicable through different market cycles. This can be found near the front of the prospectus, right after the narrative, description, investment objective, goals, strategies, and risks. There will be a bar chart showing the fund’s annual total returns for each of the last ten years or since its inception. Fees for fund management services and various administrative and sales costs can reduce the return on your investment. These are charged, in almost all cases, whether the mutual fund has a positive or negative return on investment.
Redeeming your mutual fund investment in the short-term could significantly impact your overall rate of return due to sales commissions and redemption fees that may be applicable.
A variety of share classes available can make it harder to interpret which would be the best investment for one person’s situation to the next.
In summary, choosing the right mutual fund to fit into your portfolio can be very complex. Every mutual fund is different and you should consult the each mutual fund’s prospectus for the exact terms of the offering. I would also urge you to seek input from your financial and tax professional to make sure the final decision is suitable and tailored for your individual financial goals.
Please consider the investment objectives, charges, risks, and expenses carefully before purchasing a variable annuity. For a prospectus containing this and other information, please contact a financial professional. Read it carefully before you invest or send money.
PPG118495 (9/16)(Exp 9/18)
I think the other advisors have done a good job summarizing the advantages and disadvantages of mutual funds. However, I wanted to elaborate a little bit on the cost of mutual funds.
There are charges in addition to the expense ratio, sales charges and possible tax liabilities that come from a mutual fund. These costs include cash drag and soft dollars. This Forbes article goes into detail on that. My summary of those two charges is below.
Cash Drag: Compared to index funds, mutual funds generally hold a higher percentage of cash. Since, over time, this cash will not earn you as much return as stocks or bonds, your return is negatively affected.
Soft Dollars: Soft dollars are complicated. Essentially, the mutual fund management team willingly pays an artificially higher price to make trades at a brokerage firm. That brokerage firm sends part of that trade commission to a third party service provider. Then, that third party service provider provides the mutual fund company with products and services.
There are limits to what those products and services can be. However, the bottom line is that the fund investors pay more to make trades so that the mutual fund company has access to free services from third party companies.
Neither soft dollars or cash drag is included in the expense ratio or sales charge.
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.
Please indicate if this answer was helpful for you!
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.
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!