Mutual funds are currently the most popular investment vehicle for the majority of investors but before investing in one its crucial to understand the advantages they offer as well as the disadvantages.

Mutual Funds: An Overview

There are a variety of funds covering different industries and different asset classes available. Some of the advantages of this kind of investment include advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing.

Disadvantages include high expense ratios and sales charges, management abuses, tax inefficiency, and poor trade execution.

Here's a more detailed look at both the advantages and disadvantages of this investment strategy.

Advantages of Mutual Funds

There are many reasons why investors choose to invest in mutual funds with such frequency. Let's break down the details of these benefits.

Advanced Portfolio Management

When you buy a mutual fund, 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 getting professional 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, therefore helping your investment grow.

Risk Reduction (Safety)

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 the focus. Several stock index mutual funds own 1,000 or more individual stock positions.

Convenience and Fair Pricing

Mutual funds are easy to buy and easy to understand. 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.

[Important: As with any type of investment, the specifics of your budget, timeline and profit goals will dictate what the best mutual fund options are for you.]

Advantages of Mutual Funds

However, there are also disadvantages to being an investor in mutual funds. Here's a more detailed look at some of those concerns.

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 are considered to be on the higher cost end. Be wary 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 gains 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.

Key Takeaways:

  • Mutual funds are the most popular investment choice in the U.S.
  • Advantages for investors include advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing.
  • Disadvantages include high fees, tax inefficiency, poor trade execution, and the potential for management abuses.