For many investors, mutual funds are preferable to stocks because they offer diversification and tend to be less volatile than stocks. Mutual funds are also generally more cost-effective when it comes to transaction costs and other fees. While that's an advantage, it's still possible for investors to cost themselves money unnecessarily when investing in these funds. Here are four potentially costly missteps to avoid if mutual funds are a part of your portfolio.(For more, see the tutorial: Mutual Fund Basics.)
Mutual funds are designed to allow investors to invest to spread out risk over different asset classes and types of securities. Some mutual funds may include hundreds of different stocks, along with a mix of bonds, which offer a measure of protection if one or more of the underlying investments doesn't meet performance expectations. While that's good for investors, it can cause you to unwittingly concentrating too much of your mutual fund holdings in one sector. (For more on sector funds, see: An Introduction To Sector Funds.)
This can be especially problematic for investors who put large amounts of money into index funds. If you've invested heavily in a specific index fund, such as the Standard & Poor 500 Index (S&P 500) and you also have substantial holdings in a financial sector fund, for example, that increases your risk exposure. If financial stocks take a tumble, there may not be enough balance in your asset allocation to offset the impact.
2. Being Oblivious to Cost
A mutual fund's expense ratio represents the annual cost of owning the fund. Included in the expense ratio are administrative fees, management fees, 12b-1 fees, operating costs and any other expenses that are necessary to maintain the fund. The ratio is expressed as a percentage, which represents how much of your individual fund assets you're expected to pay for your investment each year.
According to Morningstar, the average asset-weighted expense ratio across all funds, including exchange-traded funds (ETFs) was 0.64% in 2014. While there are plenty of funds that offer a lower expense ratio, there are also funds that are much more expensive. Investors who focus solely on returns while ignoring the expense ratio of a particular fund may be shortchanging themselves.
For example, let's assume you invest $10,000 in a fund with a 2% sales load and a 0.64% annual expense ratio. Assuming a 6% annual return, your investment would be worth roughly $27,000 once the fees have been deducted. Overall, that represents a nearly 14% reduction in the fund's future value. With an expense ratio of 1.5%, your investment's value would be reduced by nearly 28%. Weighing the long-term cost against the anticipated returns can prevent investors from inadvertently shrinking their portfolio. (To learn more about expense ratios, read: Pay Attention To Your Fund's Expense Ratio.)
3. Forgetting to Factor In Taxes
Mutual funds, like any other investment, are subject to the federal capital gains tax. This tax applies when shares of a mutual fund are sold for a profit, or the underlying investments in a fund are sold, and a distribution is paid out to investors at the end of the year. When a mutual fund has a higher turnover ratio, which refers to how often the fund's holdings are replaced with new investments, that can increase the investor's tax liability.
Investing in mutual funds with a lower turnover ratio, such as an ETF, is one way to increase tax efficiency. Tax loss harvesting is another option for minimizing the tax bite at the end of the year. This strategy involves selling off underperforming investments and claiming the loss on your taxes to offset capital gains. At the same time, you replace the asset you sold with one that's similar to maintain the same asset allocation. Just bear in mind that the new fund can't be substantially similar to the old one under the IRS wash sale rule. (For more on tax loss harvesting, see: How Tax Loss Harvesting Can Save You Money.)
4. Choosing a Fund That Doesn't Fit Your Investment Style
Mutual funds fall into two main categories: actively managed and passively managed. Active management means that a fund manager is responsible for deciding which securities to include in the fund. With passively managed funds, the fund assets are a reflection of a larger market index and holdings remain relatively static. As a result, they tend to carry fewer fees than their actively managed counterparts.
If you're more of a hands-on investor, you may not be as concerned with the higher fees that go along with an actively managed fund or the commission costs you'll pay to trade shares of an ETF. On the other hand, if your goal is generating passive income, a lower cost index fund can save you money. Because index funds are structured to match the performance of the particular index they track, they also offer a steady rate of return.
The Bottom Line
Mutual funds carry a number of advantages for investors who want to build a diverse portfolio, but they can easily become a money pit if you're not careful. Before investing in any mutual fund, it's essential that you understand what the upfront and long-term costs are, how you stand to be impacted in terms of taxes and how the fund matches up with your preferred investment strategy.