Before you start investing, especially in your 401K, it’s important to consider the advantages and disadvantages of mutual funds. A mutual fund is a type of professionally managed investment that allows a group of investors to pull their capital together and purchase securities, while sharing the burden of administrative and trading costs. There are many different types of mutual funds; open-ended funds sell an unlimited number of shares publicly, either in bulk or to retail investors (individuals), while close-ended funds limit their offering and once full, accept no more investors or capital.
Other categories of differentiation are managed vs. passive, what industries or sectors they invest in (technology, industrial, financials, oil and gas, consumer services, consumer goods, healthcare, telecommunications, utilities, etc), the types of securities they purchase (stocks, bonds, real estate, mortgage-backed securities, commodities, money markets), the size of the companies they target (large, mid, or small market capitalization), and the investment style (value, growth, or a blend of both).
All investment opportunities come with advantages and disadvantages, and while mutual funds are a good choice for many investors, they may not be the best choice for everyone. It is essential to weigh factors like risk vs. return, fees and costs, diversification, tax liability, and other options when investing for your retirement or a child’s education. As part of a complete stock portfolio, mutual funds can play an important role in growing your wealth.
Advantages of Mutual Funds
One of the major advantages of a mutual fund is diversification, since they invest in a variety of stocks, bonds, or securities to maximize returns and minimize risk. Studies have shown that, if done properly, investors can diversify and spread risk by buying between 20 and 50 different stocks.
Instead of incurring the trading fees of brokerage houses, it is simpler to invest in one that will allocate money on your behalf and minimize the risk of a concentrated position by instantly offering diversification. Further diversification can even be achieved by investing in multiple funds of varying investment styles, sectors, or types.
Anyone planning to invest should examine the fund’s prospectus to find out exactly which stocks and bonds, as well as the percentage of each, are included in their portfolio. If the fund is concentrated in one industry and only owns stock in dozens of different companies within the sector, the risk may be higher since losses may affect the entire industry and not just one or two companies. Although diversification does minimize the risk of losses, it may not maximize returns for shareholders if one stock’s positive performance is offset by another’s loss.
Professional Financial Management
Managing investments like stocks and bonds properly takes considerable research, time, and training. Individual management of stock portfolios is expensive and most retail investor’s can not afford the best professional managers, but by pooling together large amounts of capital and sharing costs with others, those with limited capital can still enjoy the benefits of professional financial management.
This includes individuals highly trained working full-time to maximize your returns by researching securities to buy. Additionally, because the management team’s compensation is tied-in to the performance of the fund, clients and managers have aligning interests.
One way to spot a credentialed fund manager or finance professional is by researching whether he/she is a CFA or Chartered Financial Analyst, and has had the wherewithal to join IMCA, the Investment Management Consultants Associations.
People who invest in mutual funds do not have to be stock market gurus or have extensive knowledge about the advantages of different types of bonds since a professional manager makes all investment decisions. The mutual fund company and its managers then get a percentage of the profits that exceed the benchmark set plus administrative fees, which are all divided amongst investors as a percentage of their capital compared to the total size of the fund.
Lower Trading Fees and Costs
When stocks and bonds are bought and sold, there are fees charged for each transaction by brokerage houses and electronic trading systems. The larger the amount that is traded, the lower the percentage of the fee compared to the total transaction. Not only that, the cost of transaction fees is shared among all investors, which makes these funds attractive compared to individual trading in stocks and bonds.
Fees and total costs are one of the most important factors to consider when choosing a fund. A professionally managed investment vehicle is expected to yield higher returns compared to the average investor or the overall market, and this is what justifies the fees they charge investors. If an investment’s fees outweigh the excessive returns earned, then there ceases to be an advantage of investing in the financial product and investors should re-evaluate their choices, possibly moving their capital to another asset class, ETF or competing manager.
It can be difficult to get cash out of some investments if the money is needed quickly, but mutual fund investments can usually be exchanged for cash within 48 hours or less. This applies to open-ended mutual funds and it can make them an attractive investment. There are no penalties and you can cash in the full value of the investment.
However, it is important to note that some investments have a lock-in period of 180 days, where you are not allowed to pull out your money until it expires or risk paying a percentage of your capital as an exit charge.
No-Load Mutual Funds
In trading, no-load means no fee for selling or buying an investment. Stocks have a load or fee with every transaction, but no-load mutual funds can be bought and sold without incurring any expense; however, this does not mean there are no costs. It just means that the company makes money on “management fees”.
Another advantage of mutual funds is that it only takes a small amount of cash to begin investing, with most funds willing to accept a minimum starting balance of $1,000. For example, the largest mutual fund companies, Vanguard and Fidelity, only require $3,000 and $2,500, respectively, to open an account. For people with limited money to invest, mutual funds can provide higher returns than savings accounts or certificates of deposit for the same amount of capital.
Disadvantages of Mutual Funds
Savings accounts and certificates of deposit have federal insurance (FDIC) that guarantees investors’ savings up to $250,000. There is usually a minimum guaranteed rate of return on these safe investments. Whole life insurance also guarantees a minimum rate of return on money paid into the policy’s cash value.
Mutual funds do not guarantee the return of or return on investments, similar to any stock purchase, so it is possible for you to lose some or all your money if the stock market crashes or the economy experiences a recession or depression. While safer than some investments, there are no guaranteed returns and superior historical performance does not indicate superior future performance.
Active vs. Passive Management
One issue that is discussed when considering different types of mutual funds is whether an investor should choose passive or index funds versus actively-managed portfolios. Passive index funds offer you the ability to buy or play the stock market as a whole by designing a portfolio mix that represents the entire market, without actually buying every single public stock and incurring high trading costs.
Passive index funds are simpler to understand, have lower fees, and offer investors exposure to the broad market, whereas actively-managed ones try to pick winners and losers according to investment research and timing the market. In the last few years, studies have shown that index funds have performed better than active managers, and that the excess returns, if any, by managers may not justify additional costs.
Note: “Alpha” is the excess return relative to the fund’s benchmark index.
Some investments like certain municipal bonds do provide tax relief. Interest income on municipal bonds is typically tax-exempt from federal, state and local income taxes if you are a resident of the state issuing the “munis”, while other investment options like IRAs, 401ks (check out this guide to understanding your 401K) certain types of life insurance offer income tax deductions and/or tax deferments to compete for capital.
Returns on taxable accounts are subject to short or long-term capital gains and income taxes. Short-term taxes apply for investments held less than a year, while long-term capital gains taxes apply for ones held over a year.
Unfortunately, since the tax issues are handled by the fund manager, individual investors have no control over how tax issues are handled or the terms of how the taxes will be paid. However, it is part of the fund manager’s responsibilities to minimize tax liability for his investors.
Over-diversification may occur when a particular industry outperforms the rest of the market, and your fund’s returns are decreased, on average, by mediocre gains or even losses in other sectors. If one stock performs particularly well while another disappoints, your net profit may be even.
Diversification can be both a negative and positive, as we pointed out earlier, depending on your experience and risk appetite; however, generally speaking, diversification is usually an advantage since no one can predict performance and it helps hedge against unexpected events, earnings shortfalls, or industry-wide breakdowns.
In order for mutual funds to maintain liquidity for investors, they must keep a certain amount of cash available for withdrawals. This is money that is not dedicated to investments and means that shareholders do not get the maximum return. In a typical year, most funds are considered fully-invested if they have 95% of their capital in the market; nonetheless, maintaining some extra cash for buying opportunities can be a benefit if the market is overbought or overpriced and is waiting for a dip to purchase securities at a discount to their intrinsic value. This can be one of the advantages of actively-managed mutual funds.
Management, Trading and Operating Fees
Mutual funds typically have fees that are paid by shareholders purchasing or selling shares and annual operating fees that are between 1% and 3% of the assets under management. Operating fees are deducted from investor accounts. These fees reduce the amount of returns and if the fund has a bad year with low or no returns, part of the original investment can be lost, unless the fund decides to reduce or eliminate its management fees on a bad year to avoid withdrawals.
While the cost of professional management is lower than the cost of an individual account, it is not free and investors should compare and review fees of different funds before deciding where to invest. If you are a retail investor, this can also mean picking the best online brokerage such as E-Trade, TD Ameritrade, Scottrade, Charles Schwab, etc.
Under SEC regulations, mutual funds must have at least 80% of their assets in investments that are implied by the name of the fund. The remaining 20% of assets may be held as cash or invested as the manager chooses. The different types of investments that qualify for the 80% of assets can be fairly vague so names of funds are often chosen to attract investors and can be misleading. Individual investors should research prior to buying into it since the name and the prospectus may not tell the whole story.
Researching Mutual Funds
Unlike stocks, SEC regulations do not require mutual funds to give potential buyers specific facts like sales growth or P/E ratios. The mutual fund industry does not have to provide investors with information about their earnings per share and the specifics of how managers and research analysts recommend or choose stocks.
This makes evaluating investment choices problematic since the net assets, which funds are required to provide, give a very incomplete picture of performance. Deciding who offers the best opportunity can be difficult, and using Morningstar or Lipper Ratings based on 1-month, 1-year, 3-year, 5-year, and 10-year returns will not indicate future performance.
Mutual Fund Investing
In sum, the pros and cons of mutual funds give small investors the opportunity to enjoy the benefits of investing in stocks and other securities without many of the risks and expenses associated with individual brokerage accounts. Even though fund companies try to maximize risk-adjusted returns, there are still risks and those who are extremely risk adverse should consider more secure investments.