The Downside of Mutual Funds
Negatives and Risks to an Investment Strategy
From fees to performance, this article reviews the risks of purchasing stock and bond mutual funds.
Mutual funds can be an excellent investment strategy. They allow investors without large amounts of money to invest in the stock market, and can provide diversification.
With the many positives of mutual funds, there are still things that a prudent investor should consider before buying into this investing vehicle.
Types of Mutual Funds
Mutual funds can consist of many different types of investments. There are pure stock funds, bond funds, funds for precious metals and even funds of funds. A primary positive of mutual funds is the ability to own an investment in more than one company.
In the case of stock funds, a mutual fund may hold dozens or hundreds of stocks. To achieve this number of investments, a person buying individual stocks would have to purchase (with commissions) many stocks, and monitor them all for performance. Mutual funds have managers that take care of the administrative tasks.
Mutual fund types include managed funds, where managers select investments based on their judgment within the parameters of the fund, and index funds, where the investments are selected to equate to the components of a market index.
Negatives of Mutual Funds
- Mutual funds are not insured. The price of a fund fluctuates and investors can lose money. Even bond funds can decline, since the fund buys and sells bonds before maturity.
- Many funds perform worse than the overall market. Funds can perform poorly for a long time, and one year of outperforming the market does not guarantee future success.
- Since some market benchmarks do not count income from dividends, funds that compare to them are really performing worse than it would seem, since the funds do include income from dividends. For instance, the Dow 30 does not reflect income from dividends.
- Even funds that perform better than the benchmark can be negatively affected by a change in manager.
- Diversification reduces risk, but also lowers the chance of a high return. Focusing on a few investments may result in large losses, but also holds the potential for large gains.
- Some mutual funds still charge fees upon purchase, known as loads. It is now possible to find many no-load funds. Some funds also have additional 12-b-1 fees. It is important to review the prospectus carefully to be aware of any fees that are charged.
- Some funds charge a redemption fee if the fund is held for a short time.
- Almost all mutual funds include a management fee, which covers the cost of administrating the fund. Generally, index funds have lower management expenses than managed funds.
- Mutual funds trade only after the close of the market. If there is a major movement in the market, a mutual fund investor will only be able to take advantage of price changes at the end of the day.
- Mutual funds make distributions infrequently. Many funds make one distribution per year, and an investor can have tax implications related to transactions when they did not own the fund.
Owning a Mutual Fund
With many choices, and many fees and issues, mutual funds are not a simple investment, but can be an important means to safeguard money while earning a competitive return.
