If you are just getting started with an investment portfolio, then one of the most popular products you will see are mutual funds. These are investment programs that are funded by shareholders which trade in diversified holdings while still being managed professionally.
Over $18 trillion of assets are held in mutual funds today. That includes stocks, bonds, money market accounts, and even cash. Investors then pool their money together to help grow their overall wealth. Each mutual fund is made up of different shares that represent holdings in various business categories. It is a chance for you to purchase stocks in healthcare companies, automakers, or your favorite tech giants.
It is an especially helpful investment option for people who are retirement investing right now. It doesn’t require a lot of money to get started, but with the diversity of investments that are available, you still receive an opportunity to be confident with your cash.
There are multiple ways for you to purchase or invest in mutual funds today. If you are thinking about this as an opportunity, then here are the pros and cons that you will want to think about right now.
List of the Pros of Mutual Funds
1. You can invest in mutual funds from the convenience of your 401(k) or 403(b).
If you have a retirement savings plan through your employer, then mutual funds should be one of your top priorities. This place is one of the best spots to get started because you have access to three specific benefits.
• You can take advantage of tax-deferred growth with your investments. If you can place them into a Roth 401(k), then your portfolio grows tax-free.
• Your employer can match your contributions to instantly double the amount that you put into the retirement plan up to a certain percentage.
• It is easy to contribute to this process because you can have contributions automatically deducted from your paycheck.
2. There are two different types of mutual funds from which to choose.
When you decide to start investing in mutual funds, then you have the chance to purchase index or actively managed funds. If you choose the first option, the newer investments will seek to replicate the holdings that are in a market index like the S&P 500. If you want the latter option, then you will have the help of a professional money manager picking investments for you based on the objectives of the fund.
It is critical to remember that mutual fund objectives can vary widely, so make sure to read your prospectus in full before making your first investment.
3. Mutual funds give you an option for diversification.
Instead of putting all of your investment eggs into one basket, mutual funds will spread their holdings across several different investment vehicles. This process reduces the impact that a single security, or a class of them, will have on an overall portfolio.
Since a mutual fund may contain hundreds, if not thousands of securities, the average investor does not feel a financial impact if one of their chosen options doesn’t perform well.
4. You will receive access to expert financial management.
If this is your first foray into investing, then there is a good chance that there is some guesswork going on with your financial choices. When you work with a professional money manager who is familiar with mutual funds, then you are gaining access to that person’s years of experience. These are people who have dedicated their careers to helping investors receive the best return for the amount of risk that they are willing to take. This help makes it a lot easier for beginning investors to reach their initial financial objectives.
When you can see success happen right away as an investor, it makes you want to start building your wealth even more. That’s why mutual funds are such an exciting option to add to your portfolio.
5. There are higher levels of liquidity when working with mutual funds.
There are individual investments that you can hold in your portfolio that will not qualify for daily trading. Mutual funds are not one of them. Although these products do not offer the same liquidity as stocks, there is the option to trade them daily.
You can trade them intraday if you want, play supply order after the market closes, or cell when you want. Your orders will be fulfilled once the market closes for the day. Although this option isn’t a good choice for day traders, you’ll still have plenty of access to cash if you need it.
6. It is an excellent vehicle for reinvesting your income.
Mutual funds also offer the benefit of allowing you to reinvest your interest or dividends that come from additional fund shares. This process gives you an opportunity to grow your portfolio without worrying about purchasing additional shares or paying transaction fees to build the value. It is a structure that is very similar to the Roth IRA, but you aren’t necessarily limited to the number of dividends that you can earn – depending on your unique financial situation, of course.
7. You will find that this investment option is incredibly convenient.
If you have already spent time researching companies, bonds, and mutual funds, then you know how much time it takes to make an informed financial decision in today’s markets. Then you would need to purchase holdings that are comparable to the average mutual fund to replicate the results of either type. Once you finish that, then you must monitor all of your securities to ensure that they perform in the way that you expect. When you don’t have time to micromanage your portfolio every day, choosing mutual funds is the next best solution.
8. It gives you access to a range of investment objectives and options.
You will find that there are mutual funds available today for every type of investor. It doesn’t matter if you are aggressive, adverse to risk, or prefer more of a moderate approach. You will find investment grade bonds, emerging markets, and balanced options for your funds that can all help to create a portfolio that works exceptionally well for you.
You will even find that there are mutual funds that offer a buy-and-hold philosophy for long-term success, or you can opt for structures that require you to take out your holdings almost every day.
9. There are low minimum purchase thresholds available in the world of mutual funds.
When you work with a professional money manager, then you can begin to invest in some of the world’s largest companies for as little as $50 per month. Some providers may even have a lower threshold than this. That means you can get a piece of the stocks that would be outside of the realm of affordability for the average beginner right now. Here are some examples of what we are talking about with this advantage.
• If you wanted to purchase one share of Berkshire Hathaway Inc. Class A stock as of January 30, 2019, then you would need to pay $309,180.
• On the same date, one share of Netflix stock would cost $340.66.
• Are you interested in an investment with Google? Then you would need to pay $1,097.99 for a single share of Alphabet Inc. Class A stock.
• Are you a big fan of Amazon? Then their shares were trading at $1,670.43 at the end of the day on January 30, 2019.
Mutual funds give you access to high-growth opportunities that are typically outside of the realm of the average investor. That is why they are so advantageous in most situations.
10. Mutual funds give you access to factor exposure.
This advantage is one of the fun ways to take advantage of this investment vehicle. Investors can decide to focus on specific factors as a way to give themselves an extra layer of diversification when required. You can add mutual funds which focus on low volatility, growth, business size, or even value. It is a useful process because there are times when you are uncertain about what index options are going to be in or out of favor.
Taking advantage of the structure allows you to balance a fund because you can add items that rarely perform simultaneously, which ultimately lowers your volatility.
List of the Cons of Mutual Funds
1. You have a little control over your portfolio when you trade in mutual funds.
When you start to invest in mutual funds, then you have the opportunity to tell a professional money manager how much risk you want to take, and what types of stocks or bonds that you’d like to see in your portfolio. That is the limit of your control.
The moment that you start investing in these funds is the moment that you are giving up all of the power of your portfolio and giving it to the money managers who will run it. Your wealth is now at their mercy.
2. There are capital gains tax issues to consider with mutual funds.
If you are an investor in the United States, then anytime you sell a stock, you will be taxed on the gains that you achieve. If you are in a mutual fund, that means you will be taxed when the fun distributes gains that it makes from selling individual holdings. This rule applies even if you do not sell your shares.
That is why beginners should try to avoid funds that have a high turnover rate, or sell their holdings often because the capital gains issue could negate many of your advantages.
One simple technique to prevent this issue is to invest in mutual funds through a Roth IRA. You can also avoid immediate tax consequences by investing through a 401(k) plan, a traditional IRA, or something similar.
3. It will come with fees and expenses that you must budget before an investment.
Here is some mutual fund terminology for you. There are funds which assess the sales charge on every purchase. This cost is called a “load.” Think of it as the charge you need to pay to get access to the fund in the first place. Then there are the annual expenses which every mutual fund charges each year, usually expressed in the annual expense ratio. This cost is what you pay for doing business in the market.
You should see this cost expressed as a percentage, paid annually as a portion of your overall account value. The average for a managed fund in 2018 was about 1.5%. If you want to save money here, then opt for index funds, because their average is 0.25% for this cost. Make sure that you compare these ratios carefully since it will eat into the gains you can achieve with your investments.
4. Mutual funds can sometimes over-diversify.
If you read the average blog for any financial site, then you will hear one term preached over and over again: diversification. You want to be diversified because that will help to limit your losses when a downturn in the market occurs. When you invest in mutual funds, there are times when this becomes a disadvantage. If you hold a lot of securities from different “walks of life,” then you are less likely to gain an individual return from them in your portfolio.
Reducing the risk also takes away some of the potential for growth. Having mutual funds that create over-diversity will negate the reasons that you wanted exposure to the market in the first place.
5. There can be a drag on your cash when investing in mutual funds.
Mutual funds must maintain assets in cash to have the ability to satisfy investor redemptions. This structure also makes it possible to maintain liquidity for purchasing. You will still pay to have the fund sitting in cash because the annual expenses are assessed on all of the assets, whether they are invested in the market in some way or not.
You must budget an expense of at least 0.8% in your portfolio value each year to account for this requirement.
6. Mutual funds will have their value calculated just once per day.
Although mutual funds have more liquidity than other choices, you do not experience the same immediate gains as you would with a stock investment. The prices of a fund share are only calculated once per day. This update is just made public once daily as well.
Compared to the value of stocks which are updated frequently, allowing you to take advantage of market movements, the price of this choice is dependent upon the net asset value of every underlying security. You do have the option to create an order for buying or selling throughout the day, but the price of your order will not be set officially until the market closes.
7. It is possible to have phantom gains when investing in mutual funds.
This disadvantage is the most significant one for the beginning investor. There are times when a mutual fund must raise cash. They are allowed to sell profitable investments to generate this result. When that happens, they are creating capital gains for their investors. It doesn’t matter if the fund itself performs poorly. This process makes it possible for you to lose money on an investment, but then still end up owing taxes because the capital gains get passed along to the investors.
8. You must still keep your eye on all of your investments when choosing mutual funds.
Whenever you allow someone else to have access to your portfolio, there is an element of risk to that decision. This concern does not involve the performance of the fund itself – we’re talking about the actual people involved with trading. Almost every manager you work with will do their best to create more wealth because that helps them earn a better paycheck. There are times when management abuses do occur, so make sure that you watch for high turnover rates, churning, and window dressing actions that could impact your bottom line. It seems like there are always a few who think that selling the losers before the quarter ends to fix the books will get them off the hook.
9. It doesn’t allow you to own the actual stocks in the companies you want.
Think of mutual funds as a big pile of money. The managers of that cash are making investments into the companies that they think will help it to grow even bigger. They’ll use those funds to buy Amazon, Alphabet, Netflix, and all of those other popular stocks. It feels like you own them too in a way, but that really isn’t the case. When you purchase stock funds, then you own that and not the individual stocks that are part of the fund.
Although this technicality might seem a little strange to some beginners, here is why it is important. When you own an actual share of a company, then you have voting rights based on the equity percentage that are under your control. The mutual fund managers might have voting rights for those stocks, but you do not. Your job is to hope that the funds you choose will gain in value if given enough time.
10. There are a lot of choices to consider when selecting mutual funds.
Sometimes an investment is easier to make when there are only a couple of choices available to you. Once you start buying mutual funds, you will discover that there are a lot more of them that become a tempting proposition as well. You will still need to spend some time and resources investigating each fund that you think might be a valuable addition to your portfolio to ensure the results you achieve meet or exceed your expectations. Although some like to make decisions with their gut instinct, an informed choice is usually the better one to make.
The pros and cons of mutual funds will usually shade toward the advantages for most investors. There will always be an element of risk when you are investing money somewhere other than a savings account. It is possible to lose money with this option, even when there are funds which have a long history of success. Always read the prospectus present it to you in its entirety before finalizing a choice. There may be some ups and downs, but over a long-term perspective, this vehicle typically drives home an increase in wealth.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.