Mutual funds are a unique investment opportunity. They allow you to pool your cash together with other investors to create a collection of stocks, bonds, and miscellaneous securities that would be challenging to duplicate individually. That means you can have immediate access to a diversified portfolio to grow your wealth for a small fee each year to compensate the managers who handle the investments.
The price of a mutual fund is its net asset value. This figure gets determined by the total value of the security in the portfolio and the number of outstanding shares. It fluctuates each day based on the values of each security held at the end of the business day. You don’t own the securities as an investor – only shares of the fund itself.
Actively managed mutual funds have one or more portfolio managers and a team of researchers to help its wealth start growing. The goal of these workers is to fund investment opportunities that can help it to outperform set benchmarks. Most investments in this area should be considered 3-year, 5-year, or 10-year commitments to see the best results.
If you’re thinking about making an investment shortly, then these are the advantages and disadvantages of mutual funds to start considering.
List of the Advantages of Mutual Funds
1. Mutual funds provide an advanced level of portfolio management.
When you make the decision to purchase mutual funds, then you’re paying a management fee as part of the overall expense ratio. This cost allows you to hire, with all of the other investors, a professional portfolio manager who will buy and sell the stocks, bonds, and other securities on your behalf. Most people find that the expense of this service is a small price to pay in exchange for receiving professional assistance in the management of their investment portfolio.
2. You get to benefit from dividend reinvestment.
When you receive interest funds or dividends from sources that are in the mutual funds you purchase, then the managers can use this case to buy additional shares to help your investments grow. Some mutual funds will declare dividends or interest income that gets paid to you directly, allowing you to buy more shares of the fund to encourage additional growth. That’s why this investment option is a powerful way to start building wealth.
Although not every fund will produce massive profits, most of them can meet or exceed their benchmarks when you look at the investment as a long-term option.
3. Mutual funds provide risk reduction to your portfolio.
When you decide to invest in mutual funds, then you achieve a reduction of portfolio risk because of its use of diversification. Most of them will invest in at least 50 different securities, with some going as high as 200. Each one has a specific focus, allowing investors to choose from whatever options suit their fancy the most. Numerous stock index mutual funds own over 1,000 individualized stock positions. That’s why you typically see sustained and steady growth when you make an investment in this direction.
The gains aren’t going to be as high as you can receive with equity investments or some bonds, but it isn’t a high risk, high reward proposition. Mutual funds can typically be considered a medium-level risk for most investors.
4. It is a convenient way to start growing your money.
With interest rates as low as they are today, putting your money into a standard savings account is about as worthwhile as digging a hole to bury your cash. Even money market accounts are only offering rates in the 1% to 2% range for most people. When you decide to invest in a mutual fund, then you have the same low minimum investments as a money market account, but a lot more potential for growth.
Mutual funds only get traded once per day at the closing net asset value. That means you don’t have the same price fluctuations throughout the day as you do with other products or the various arbitrage opportunities. It is convenient, with fair pricing structures, making it a convenient option that most people can afford.
5. You have two types of mutual funds from which to choose.
When you decide to put your money into mutual funds, then there are two types from which to choose. The first is an actively managed fund where professional managers handpick the investments according to the overall objectives of the fund. The selections can vary widely, focusing on a specific industry, overseas investments, or small startups. Some like to diversify with bonds or large-cap stocks.
The second choice is an index fund. This selection isn’t actively managed like the others since they try to replicate the holdings in a specific index. Many of them choose the S&P 500.
6. Mutual funds still provide investors with some liquidity.
You receive the same options for liquidity with mutual funds as you do with stocks, although the number of trades is fewer. You can only trade them once per day since the buy and sell orders get filled after the market closes. That means you know that cash will be available at the end of the day if you need something.
That means you don’t need to worry about penalties or fees for early withdrawal as you do with a Certificate of Deposit.
7. You gain access to a range of investment objectives and options.
You will discover that mutual funds come with a wide range of investment profiles and preferences. There are choices for the aggressive investor, those who want to take a conservative approach, and those that want something in the middle. You can focus on emerging markets, use bond funds, or lifecycle funds that create less risk as you get closer to your retirement.
Many funds use the buy-and-hold philosophy, although you can also find some that get into and out of holdings almost every day. That means there is a perfect mutual fund available that matches your investing style so that you can achieve your wealth goals.
8. It makes the bigger names affordable to own as an investor.
If you have $50 per month to invest in mutual funds, then you can start to own shares of companies like Apple, Google, Amazon, and Berkshire Hathaway. Did you know that as of January 10, 2020, that a single share of Berkshire Hathaway stock was trading at over $340,000 per share? That rate is higher than what some people earn in a decade. Because of the way that mutual funds get handled, you can gain access to the impressive gains that are possible with these large companies to grow your wealth.
9. Mutual funds offer a significant level of convenience.
You don’t need to worry about spending time researching individual companies, bonds, or other securities when you invest in a mutual fund. The expense ratio that you pay with this option allows other people to do this work for you. As long as you perform your due diligence in this matter, then you can have confidence in the managers who work to grow your wealth.
You don’t need to worry about purchasing comparable holdings for your portfolio. Instead of checking on your investments daily, you can read the reports that come your way to know where your wealth is headed. It’s the perfect solution for anyone who doesn’t have a lot of time to focus on cash growth.
10. Passively-managed funds have very low fees.
Although actively managed funds have annual fees that can be as much as 2%, passively managed ones can be less than 0.1% with some choices. If you have $20,000 that you want to put into mutual funds today, that means you could be paying $400 per year to have someone help you to grow your wealth or $20 – which option makes the most sense?
Even though mutual funds don’t open or close during the trading day, you still have the option to get out if the fees seem too high.
11. Individual purchase minimums are quite low with many mutual funds.
Mutual funds are a cost-effective and intelligent way to start investing to gain some market exposure. Individual purchase minimums vary by fund, but some of them are as low as $100 in today’s market. Most of them will start letting you purchase shares with as little as $2,500, and the minimums are often waived (or at least reduced) when you use retirement accounts or specific brokerage features.
You’ll want to talk to the mutual fund manager, financial advisor, or investing platform to see if automatic investments can reduce your cost profile.
List of the Disadvantages of Mutual Funds
1. Mutual funds can come with sales charges and high expense ratios.
If you don’t pay attention to the sales charges and mutual fund expense ratios with your investment, then they can quickly get out of hand. You’ll want to be cautious with any opportunity where the expense ratio is higher than 1.2% since those are on the higher end of the cost spectrum. Advertising fees and sales charges are something that should make you wary automatically.
Several excellent mutual fund companies and managers are out there that request zero sales charges as part of the overall investment. Any time that you must pay a fee to get involved with this investment opportunity, then it reduces the overall return that you can receive.
2. Management abuses can happen with mutual funds.
Mutual funds can sometimes create managerial problems that lead to abuses of authority. You can tell which ones are dealing with this disadvantage by the high turnover rates, churning, and window dressing that happens. You might experience unnecessary trading, excessive replacements, or selling losers prior to the end of the quarter to fix the books in their favor.
You can always review the history of a mutual fund’s performance before deciding on your final investment. Do as much research as you can before putting your money somewhere. As with any type of investment, the specifics of your profit goals, timeline, and budget will dictate the options that are the best options for your financial needs.
3. Tax inefficiencies are built into this investment system.
Investors don’t have a choice regarding the capital gains payouts that happen with their mutual funds. Some people like this feature, but it can also lead to taxation inefficiencies or problems for some investors. Because of the redemptions, turnover, gains, and losses that happen with securities holdings throughout the year, distributions from the fund typically come as an uncontrollable tax event.
4. Poor trade execution can be problematic for some mutual funds.
When you place a mutual fund trade at any time before the cut-off for the same-day net asset value, then you receive the same closing price for your buy or sell on the product. Investors that want a faster execution time because of short investment horizons, market timing, or day trading will find this option to be a weak strategy to use.
Mutual funds can sometimes provide short-term gains that can lead to profits, but this investment option is geared more toward long-term wealth-building than short-term gains.
5. You don’t have control over the trading decisions that happen.
When you decide to invest in a mutual fund, then you’re giving up all control of your portfolio. The money managers who run it are going to manage your finances on your behalf. If decisions get made that wreck your financial future, then the only thing you can do is to sell your shares quickly to get out of the fund.
6. Selling your stock results in a capital gain.
If you sell your stock from a mutual fund, then the government taxes you on any capital gains you earned. That means you get hit with a tax bill in this structure when the fund sells individual holdings even if you maintain your shares in the fund. That’s why many investors try to invest in mutual funds through a Roth IRA since it uses post-tax dollars to build wealth. When you sell in that structure, then you’ll withdrawal without an additional tax responsibility.
There can be some tax advantages in traditional IRAs and 401(k) plans to consider if this problem with mutual funds is a concerning issue for you.
7. You can experience over-diversification in a mutual fund.
Although the benefits of diversification are many, you can go too far with this approach sometimes. When you hold multiple securities, then you’re less likely to feel like they’re making a positive impact on your overall portfolio. The amount of risk you face will be lower, but that also means the option for gains goes down at the same time. You won’t consider this advantage if you want to take an ultra-conservative approach to your investing, but this problem can often negate the reasons why market exposure is beneficial in the first place.
8. Mutual funds can create a cash drag for some investors.
Mutual funds must maintain cash assets so that they can satisfy investor redemptions. This need also reflects a requirement to maintain some liquidity so that purchases are possible. As an investor, you’re paying to have that fund sit on some cash because annual expenses get assessed on all fund assets, whether they receive investment activities or not. This disadvantage is an expense that averages about 0.8% of the annual portfolio value for each investor who uses this option.
9. Mutual funds are not a hands-free solution to investing.
Although you don’t need to spend as much time reviewing your portfolio when investing in mutual funds, you still need to keep an eye on things. Plenty of managers take an ethical approach to wealth growth, but there are a few bad apples out there that will take advantage of a lack of oversight. If you don’t catch management abuses early, then it could impact your bottom line in massive ways before you even realize what is going on.
If you’re trying to create short-term gains, then a mutual fund is not the best solution. You don’t need to worry about volatility because a five-year perspective changes your strategy. If an investment gives negative returns for the near term, you don’t need to panic. Keep investing as you accumulate more units at the same price because in the long run, this act will help you to generate more wealth.
10. There are times when liquidity isn’t available with mutual funds.
Mutual funds have more liquidity than some other investments, but it isn’t a guaranteed benefit. If a significant financial event occurs in an economy, then there might not be investor interest in purchasing the shares that you make available. That means you’re left holding the bag on whatever value remains until someone comes along to make a purchase. The last time we saw this disadvantage, it happened in the United States during the financial crisis years of 2008 and 2009.
Did you know that there are more mutual funds available for investors to consider than individual stocks? That means the chances of finding one that meets your exact needs are relatively high. It is an investment option that is appropriate for anyone who doesn’t have the time or inclination to get heavily involved in portfolio management. You’ll pay an annual expense ratio for the privilege of having someone do the work for you, but it can lead to higher wealth in time.
Mutual funds are also ideal for anyone who needs the level of diversification that’s available in this investment option. If you need a low-fee option, then index funds are a suitable solution for many investors.
The advantages and disadvantages of mutual funds are essential to consider as you find ways to gain more market exposure. Your money isn’t going to grow if you keep it in a savings account. Although no investment options are free from risk, you’ll find that many mutual funds offer a way to meet or beat inflation each year so that your money can at least hold the same value tomorrow as it does today.
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.