The Advantages and Disadvantages of Mutual Funds

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 then be invested in many vehicles, including stocks, bonds, short-term debt and alternative investments. Investors buy shares in mutual funds and each share represents their ownership in the fund and any income it generates.

The Advantages of Mutual Funds

Diversification: 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 20 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 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 investments and subsequent purchases. For example, many fund families allow you to begin buying units or shares with a small dollar amount (e.g. $500) for the initial purchase. Some mutual funds also permit you to buy more units on a regular basis with even smaller installments (e.g. $50 per month) allowing you to invest small dollar amounts in many companies. This allows an individual to own all of the underlying investments of the fund that may not have been affordable to purchase individually. (For related reading, see: The Advantages of Mutual Funds.)

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 do 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 on 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. (For related reading, see: What Items Are Considered Liquid?)

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, etc.) and allow you to switch between these funds at little to no charge. This enables you to change your portfolio balance as personal needs, financial goals or market conditions change.

The Disadvantages of Mutual Funds

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 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 one, three, five and 10 years 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 and 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 10 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. (For related reading, see: Digging Deeper: The Mutual Fund Prospectus.)

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.

Understand the Terms Before Investing

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 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.

(For related reading, see: Mutual Funds: What Are They?)

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