Mutual Funds Definition Advantages and Disadvantages

Mutual funds are suitable for those looking to dip their toes in the world of investing. While financial know-how is always a good thing to have when undertaking such ventures, mutual funds ultimately leverage on the expertise of people in the industry, making it accessible to budding and experienced investors.

What are Mutual Funds?

Mutual funds, essentially an entity that acquires ownership in different fund companies. Instead of purchasing stocks individually, you would have a broad portfolio making for a simpler transaction.

This is achieved through pooling resources together into some type of investment vehicle, where investors mutually contribute, or where they purchase a variety of different stocks or bonds or a combination of both and grow it over a period of time.

Types of mutual funds

There are 2 types of Mutual funds: index funds and actively managed funds

Index funds make keeping track of investments easier, as they replicate the portfolio of a particular market index. Investing in index funds gives you the simple goal of buying all the companies in an index. This means that an S&P 500 fund buys all the companies in the S&P 500 index.

Opposite to index funds, active funds are comparatively more of a gamble. They seek to purchase less companies in hopes that these stocks perform better than others in the index, and it is this performance that investors measure the active funds’ failure or success.

Active funds are highly dependent on an active manager’s skill in picking winning stocks; ergo, usually charge higher fees as compensation.

While a valid approach, this might be too fickle a venture for beginning investors, as active fund managers cannot consistently add value through stock picking and market timing. It’s important to consider whether the efforts of the active manager is worth the higher expense ratio and annual.

Mutual Funds: Advantages and Disadvantages

Mutual fund investors may benefit from the convenience, risk reduction, fair pricing, dividend reinvestment, and advanced portfolio management. The less-than-ideal side of the coin includes tax inefficiency, poor trade execution, and the increased likelihood of management abuses.

Advantages of Mutual Funds

1. Diversification

For safe and consistent returns in mutual funds, it is generally a better idea to spread out your investments into multiple funds, as singular, active funds can still be susceptible to market volatility no matter how good the performance record.

Diversifying your money among various funds with different risk profiles will keep your money secure even for a long-term investment. This also has the added benefit of cushioning the effects of market fluctuations due to having your assets allocated among diverse funds, ultimately reducing the risk associated with your return on investment.

Spreading your investments overstocks with different securities and risk profiles helps mitigate loss, as this protects other stocks within the fund when one underperforms.

Simply put, mutual funds are a horse race where there can be more than one winner, and hedging your bets on multiple racers exposes you to less risk.

2. Expert management

Convenience is the main advantage of mutual funds, an efficient way to earn in the stock market without the trouble of navigating it yourself and managing your money.

This is especially true for those without much time and experience in stocks. Your investments will be handled by skilled fund managers, trained in preventing loss and yielding profits through strategic trading, while considering macroeconomic factors, your risk appetite, ideal time horizon, and financial objective, among others, allowing you a less worrisome investment venture.

3. Liquidity

Mutual funds are considered the most flexible form of investment. You can withdraw or redeem all or part of your investment(s) at your convenience. Your money is always accessible to you. Moreover, the method of accessing is standardized, making it swift and prompt.

4. Reinvestment of income

You can purchase additional shares by using dividends and other interest income sources as they become declared in the mutual fund, which can help grow your investment.

5. Range of investment options

Within mutual funds, there are different types in which you can partake: growth funds, income funds, money market funds, balanced funds, index funds, asset allocation portfolios, target-date funds. A diverse portfolio exposes you to these different investments, opens more options and opportunities.

6. Convenience & affordability

Another advantage of mutual funds is that it makes investing accessible to those with a minimal budget. Some mutual funds let investors buy-in with no minimum at all, you can begin your mutual fund investment even with as low as $5.

Disadvantages of Mutual Funds

1. No control over your portfolio

By entrusting your mutual funds to your fund managers, you lack control over portfolio customization. Fund managers are in charge of the decision making when it comes to purchases and sales.

While fund managers honor your investment philosophies, moments of conflict when it comes to strategies are inevitable and is something to consider.

2. Locked in clause

These require investors to hold their money for a specific period, the duration varies on the type of mutual fund you have acquired. Investors are not allowed to buy or sell units until the end of this period.

3. High fees and charges

Another disadvantage when you avail of professional management is the management fees. Management of funds is paid for via expense ratio, which is the percentage that serves as compensation for the fund manager’s time and skills.

Since actively managed funds are more diverse, managers are engaged in purchases and sales more, which increases the expense ratio, as each transaction requires payment. Mutual funds usually charge 1-3% commission per year which eats up your profits in the long term.

4. Over-diversification

When rebalancing stocks and bonds, a diverse portfolio can help stabilize your original asset allocation. However, it takes more time than you should ideally spend.

To acquire a diversified portfolio, you would need to acquire multiple different stocks with different asset classes and risk levels, not to mention the transaction fee you would have to pay for every purchase.

5. Tax inefficiency; high capital gains

Among the disadvantages of mutual funds are tax inefficiency and high capital gains. You are still responsible for the entire year’s taxable gains, no matter when you purchased within the year. These are referred to as embedded gains.

The downsides are you pay taxes and other fees, even after technically having a loss, and it may negatively affect an investor who may not desire to pay the fees required of additional taxes despite not expecting it or an investor who is at the top of the tax bracket where these gains are taxed at higher rates.

6. Poor trade execution

The buying or selling of mutual funds take place at the close of the market regardless of when you entered the order for the transaction. Many advocates of ETFs, however, will point out that you can trade with ETFs throughout the day.

While it’s possibly true that your order can be fulfilled earlier in ETFs than in mutual funds, the time difference is considerably small, and the consistency of singular time for transactions itself can be appealing.

7. Liquidity costs

One disadvantage of mutual funds is that it is not often easy to liquidate a portfolio, and it can be dependent on market liquidity for security.

Are Mutual Funds Right for You?

Determining a road map for any journey requires you to be aware of both the starting and endpoints. This is the same with mutual funds. You must first analyze your situation, specifying your needs and goals, and from here, consider your own risk appetite appropriate to your situation.

For example, if you are investing in mutual funds for your retirement account while your retirement is many years away, it might be ideal to look into considerably riskier, but more rewarding ventures due to the extensive timeframe.

In this case, an aggressive, low-expense fund might be for you, and because you aren’t liable for capital gains on investments in qualified retirement accounts, investing in mutual funds with high turnover that distribute capital gains every year is something to consider.

In the purpose of purchasing real estate within a shorter time frame, a fund that doesn’t often distribute capital gains and isn’t as aggressive will be the better choice.

Closing

Mutual funds are the perfect fit for people without the time nor experience to involve themselves in the management of an investment portfolio and do not mind paying annual fees for professionals who make it their responsibility.

Mutual funds are also ideal for people who simply cannot afford the level of diversification that most funds offer. If you are one of the people who desire low expense ratios without the need for professional management, index funds may also be another ideal option.

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