Advantages/Disadvantages Of Mutual Funds

[Leth]

The Advantages and Disadvantages of Investing in Mutual Funds
by Investopedia

Advantages

Since their creation, mutual funds have been a popular investment vehicle for investors. Their simplicities along with other attributes provide great benefit to investors with limited knowledge, time, or money. To help you decide whether mutual funds are best for you and your situation, we are going to look at some reasons why you might want to consider investing in mutual funds.

Diversification

One rule of investing that both large and small investors should follow is asset diversification. Used to manage risk, diversification involves the mixing of investments within a portfolio. For example, by choosing to buy stocks in the retail sector and offsetting them with stocks in the industrial sector, you can reduce the impact of the performance of any one security on your entire portfolio. To achieve a truly diversified portfolio, you may have to buy stocks with different capitalizations from different industries and bonds having varying maturities from different issuers. For the individual investor this can be quite costly.

By purchasing mutual funds, you are provided with the immediate benefit of instant diversification and asset allocation without the large amounts of cash needed to create individual portfolios. One caveat (beware), however, is that simply purchasing one mutual fund might not give you adequate diversification - check to see if the fund is sector or industry specific. For example, investing in an oil and energy mutual fund might spread your money over fifty companies, but if energy prices fall, your portfolio will likely suffer.

Economies of Scale

The easiest way to understand economies of scale is by thinking about volume discounts: in many stores the more of one product you buy, the cheaper that product becomes. For example, when you buy a dozen donuts, the price per donut is usually cheaper than buying a single one. This occurs also in the purchase and sale of securities. If you buy only one security at a time, the transaction fees will be relatively large.

Mutual funds are able to take advantage of their buying and selling size and thereby reduce transaction costs for investors. When you buy a mutual fund, you are able to diversify without the numerous commission charges. Imagine if you had to buy the 10-20 stocks needed for diversification. The commission charges alone would eat up a good chunk of your savings. Add to this the fact that you would have to pay more transaction fees every time you wanted to modify your portfolio - as you can see the costs begin to add up. Mutual funds are able to make transactions on a much larger scale (and cheaper).

Divisibility

Many investors don't have the exact sums of money to buy round lots of securities. One to two hundred dollars is usually not enough to buy a round lot of a stock, especially after deducting commissions. Investors can purchase mutual funds in smaller denominations, ranging from $100 to $1000 minimums. So, rather than having to wait until you have enough money to buy higher-cost investments, you can get in right away with mutual funds. This leads us to the next advantage.

Liquidity

Another advantage of mutual funds is the ability to get in and out with relative ease. You can sell mutual funds at any time as they are as liquid as regular stocks. Both the liquidity and smaller denominations of mutual funds provide mutual fund investors the ability to make periodic investments through monthly purchase plans while taking advantage of dollar-cost averaging.

Professional Management

When you buy a mutual fund, you are also choosing a professional money manager. This manager will use the money that you invest to buy and sell stocks that he or she has carefully researched. Therefore, rather than having to research thoroughly every investment before you decide to buy or sell, you have a mutual fund's money manager to handle it for you.

As with any investment, there are risks involved in buying mutual funds. These investment vehicles can experience market fluctuations and sometimes provide returns below the overall market. Also, the advantages gained from mutual funds are not free: many of them carry loads, annual expense fees and penalties for early withdrawal. In the next article we will take a closer look at some of these drawbacks so you can decide if mutual funds are right for you.

Disadvantages

Like many investments, mutual funds offer advantages and disadvantages, which are important for you to consider and understand before you decide to buy. Here we explore some of the drawbacks of mutual funds.

Fluctuating Returns

Mutual funds are like many other investments without a guaranteed return. There is always the possibility that the value of your mutual fund will depreciate. Unlike fixed-income products, such as bonds and Treasury bills, mutual funds experience price fluctuations along with the stocks that make up the fund. When deciding on a particular fund to buy, you need to research the risks involved - just because a professional manager is looking after the fund, that doesn't mean the performance will be stellar.

Another important thing to know is that mutual funds are not guaranteed by the U.S. government, so in the case of dissolution, you won't get anything back. This is especially important for investors in money market funds. Unlike a bank deposit, a mutual fund will not be FDIC insured.

Diversification?

Although diversification is one of the keys to successful investing, many mutual fund investors tend to overdiversify. The idea of diversification is to reduce the risks associated with holding a single security; overdiversification (also known as diworsification) occurs when investors acquire many funds that are highly related and so don't get the risk reducing benefits of diversification. To read more on this subject, see this article.

At the other extreme, just because you own mutual funds doesn't mean you are automatically diversified. For example, a fund that invests only in a particular industry or region is still relatively risky.

Cash, Cash and More Cash

As you know already, mutual funds pool money from thousands of investors, so everyday investors are putting money into the fund as well as withdrawing investments. To maintain liquidity and the capacity to accommodate withdrawals, funds typically have to keep a large portion of their portfolio as cash. Having ample cash is great for liquidity, but money sitting around as cash is not working for you and thus is not very advantageous.

Costs

Mutual funds provide investors with professional management; however, it comes at a cost. Funds will typically have a range of different fees that reduce the overall payout. In mutual funds the fees are classified into two categories: shareholder fees and annual fund-operating fees.

The shareholder fees, in the forms of loads and redemption fees, are paid directly by shareholders purchasing or selling the funds. The annual fund operating fees are charged as an annual percentage - usually ranging from 1-3%. These fees are assessed to mutual fund investors regardless of the performance of the fund. As you can imagine, in years when the fund doesn't make money these fees only magnify losses.

Misleading Advertisements

The misleading advertisements of different funds can guide investors down the wrong path. Some funds may be incorrectly labeled as growth funds, while others are classified as small-cap or income. The SEC requires funds to have at least 80% of assets in the particular type of investment implied in their names. The remaining assets are under the discretion solely of the fund manager.

The different categories that qualify for the required 80% of the assets, however, may be vague and wide-ranging. A fund can therefore manipulate prospective investors by using names that are attractive and misleading. Instead of labeling itself a small cap, a fund may be sold
under the heading growth fund. Or, the "Congo High-Tech Fund" could be sold with the title "International High-Tech Fund".

Evaluating Funds

Another disadvantage of mutual funds is the difficulty they pose for investors interested in researching and evaluating the different funds. Unlike stocks, mutual funds do not offer investors the opportunity to compare the P/E ratio, sales growth, earnings per share, etc. A mutual fund's net asset value gives investors the total value of the fund's portfolio less liabilities, but how do you know if one fund is better than another?

Furthermore, advertisements, rankings and ratings issued by fund companies only describe past performance. Always note that mutual fund descriptions/advertisements always include the tagline "past results are not indicative of future returns". Be sure not to pick funds only because they have performed well in the past - yesterday's big winners may be today's big losers.

Conclusion

When you buy any investment, it's important to understand both the good and bad points. If the advantages that the investment offers outweigh its disadvantages, it's quite possible that mutual funds are something to consider. Whether you decide in favor or against mutual funds, the probability of a successful portfolio increases dramatically when you do your homework.

[aiki14]

I do not invest in mutual funds, except for foreign exposure. There are tax benefits of holding the individual stocks as opposed to a mutual fund, by holding a portfolio of stocks I can sell a position for a tax loss 1 day short of a year hold, and sell for a gain 1 day after a year hold and write the loss off against regular income, and the gain is long term capital gains. Mutual funds pay out the gains at the end of each year and are short term cap gains. Short term of course have a higher tax liability.