When are mutual funds considered a bad investment?
Mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high expense ratios charged by the fund, various hidden front-end and back-end load charges, lack of control over investment decisions and diluted returns.
High Annual Expense Ratios
Mutual funds are required to disclose how much they charge their investors annually in percentage terms to compensate for the costs of running investment businesses. A mutual fund's gross return is reduced by the expense ratio percentage, which could be very high - in the range of 2% to 3%. Historically, the majority of mutual funds generated market returns. Excessive annual fees can make mutual funds an unattractive investment, as investors can generate better returns by simply investing in broad market securities.
Many mutual funds have different classes of shares that come along with front or back-end loads, which represent charges imposed on investors at the time of buying or selling shares of a fund. Certain back-end loads represent contingent deferred sales charges that can decline over several years. Also, many classes of shares of funds charge 12b-1 fees at the time of sale or purchase. Load fees can range from 2% to 4%, and they can also eat into returns generated by mutual funds, making them unattractive for investors who wish to trade their shares often.
Lack of Control
Because mutual funds do all the picking and investing work, they may be inappropriate for investors who want to have complete control over their portfolios and be able to rebalance their holdings on a regular basis. Because many mutual funds' prospectuses contain caveats that allow them to deviate from their stated investment objectives, mutual funds can be unsuitable for investors who wish to have consistent portfolios.
Mutual funds are heavily regulated and are not allowed to hold concentrated holdings exceeding 25% of their overall portfolio. Because of this, mutual funds tend to generate diluted returns, as they cannot concentrate their portfolios on one best-performing holding.
The short answer is mutual funds are a bad investment when they don't align with your investing philosophy and/or risk tolerance.
There are thousands of mutual funds out there. There is a mutual fund for just about every investing style, philosophy, and risk tolerance that is out there. They are a great way to get diversification compared to having to purchase 20+ different stocks/bonds in a variety of industries.
Things to keep in mind when investing in mutual funds...
1. Fees- Pay close attention to the internal fees (known as the expense ratio) as well as if there are any sort of loads (commissions) paid on the front end or back end of the fund. Many mutual funds are a lot more expensive than their index fund counter parts (mutual funds compare themselves to benchmarks known as indexes... in many cases you can purchase an index fund for significantly less fees).
2. Investing style of the fund- Is the fund actively managed? Passive? What does the fund invest in? Is it from a reputable company? Where do they invest? Growth? Value? Bonds? US? Intl? How often do they change it? Is it something you understand?
3. Risk tolerance- All investments carry some sort of risk. Are you comfortable with the level of risk that this particular fund is taking? Does it align with your overall philosophy to help you achieve your goals?
At the end, it is important to understand what you're buying, the risks, and the fees you're paying for any investment you make. If you are not comfortable with those things then you should either ask more questions or walk away.
Here are some general situations when mutual funds would be considered a bad investment:
HIGH EXPENSES & FEES: This is probably the single biggest problem with many mutual funds. High expense ratios and high front end and back end loads can chew up returns. Look to make up your investment portfolio with lower cost Exchange Traded Funds. You can find hundreds of options to choose among with annual expense ratios of 0.25% or less. This will leave more money growing in your account and less money going out the door in unnecessary fees.
OVERLY COMPLEX PRODUCTS: Another guiding principle of investing that I have is don't invest in anything that you do not understand well. People get themselves into trouble investing in products with a lot of slick marketing copy, but with little understanding of how their money is actually invested. For each of your fund choices, you should know exactly what you're investing in. Once again, you can choose ETF's that invest in specific asset classes including US Stocks, International Stocks, Emerging Markets, Real Estate, Bonds, and US Treasuries among many others. If something sounds too good to be true, it probably is and you'll be better served sticking with easy to understand funds that enable you to know and understand how your money is being invested.
Hope you found this helpful!
With Kind Regards,
When they go down. In all seriousness, a mutual fund is a tool just like other investment vehicles. And the mutual fund is really a receptacle, technically a type of entity, to hold the investments within the fund. It really isn't a question of being good or bad, but rather does it suit your needs. The investments within a mutual fund can range from conventional stocks and bonds, to commodities and even currencies. A few even specialize in short selling and/or use leverage. So depending on what you are trying to do, they could be a valuable tool to achieve your goals. But if used incorrectly, they could do much harm.
I am assuming though, based upon your question, you are referring to more conventional stock or bond mutual funds. Those "vanilla" funds are a good way to get exposure to stock or bonds and diversification at the same time.
One thing you might want to research are Exchange Traded Funds, or ETFs. These are the "new" generation of mutual funds that can do everything stated above. Unlike the conventional mutual fund, it can be sold during the day like a stock. This is in contrast to a mutual fund where you have to wait until the end of the day closing price known as the NAV, or Net Asset Value. The SPDR S&P 500, ticker symbol SPY, was the first ETF created in the mid 90s and mimics the S&P 500. Similarly, the PowerShares QQQ NASDAQ 100, ticker QQQ, invest in the largest 100 companies on the NASDAQ like Microsoft, Apple, Amazon, Google, Intel, and many large cap bio-techs. These two ETFs in combination could provide broader exposure to the two major broad indices efficiently. And there are many others including sector specific ETFs. Vanguard has many very low cost ETFs including Total Market, stocks or bond, ETFs.
Mutual funds can do this exact same thing, but you just don't have the added benefit of selling during the day, which in most cases, won't be an issue. I just prefer to have as much flexibility as possible, so why not have the added perk without a downside.
This should be plenty of information to get you started on your research journey. Best of luck, Dan Stewart CFA®
Mutual funds should not be purchased for short holding periods. Like the stocks and bonds they purchase, mutual funds are long term investments for the wide majority of investors who use them. Long term investments should only be purchased when you intend to hold them for at least 5 years. If you need a steady income stream, you can still purchase mutual funds as long as you intend to stay invested over a long term distribution period. The best example of an income stream over a long distribution period is retirement, so mutual funds are appropriate for retirement income.
I believe there are a few circumstances where mutual funds would not be an appropriate investment:
1. As the Investopedia answer mentions, very high fee mutual funds are rarely going to be your best option. Believe it or not, between management fees and transaction costs, higher end fees could be costing you over 5% per year. It's difficult to imagine there being a lot of gain left for you after those types of costs!
2. If you need your money to be safe - generally speaking, most mutual funds are invested into securities like stocks and bonds which means risk of principal. There are many circumstances where you should not be risking your principal. For example, let's say you've saved money and will be buying a car in six months. I would suggest you keep your money in a money market account rather than risking it for such a short period of time.
3. You've accumulated a substantial amount to invest. One of the greatest benefits of mutual funds is often a low minimum investment amount. This allows many people to invest and provides them with much needed diversification. However, if you've been saving and investing for some time and have accumulated a substantial amount, say over $250,000, you may find better alternatives than mutual funds. I would suggest you look into ETFs, separately managed accounts as well as alternative-style investments. Broadening your horizons beyond mutual funds may offer you lower fees, greater control, and/or more comprehensive diversification.