Even though mutual funds remain among the most popular investment vehicles, it’s important to understand the advantages and disadvantages of mutual funds. While they can be profitable, consistent, low-maintenance sources of capital growth, they have a few potential drawbacks that could be difficult to manage or overcome.
In this post, Gorilla Trades takes a closer look at the structure of mutual funds, how they are positioned in the modern investment marketplace, and some pros and cons of putting your capital in the fund manager’s hands.
What Is a Mutual Fund?
A mutual fund is a sort of pool into which multiple investors inject capital. The pool is a combination of diverse investment vehicles, including stocks, bonds, real estate trusts, alternative commodities, and more — literally any security available to everyday investors.
The mutual fund is overseen by a professional manager who drives the fund toward its primary aim, whether that’s generating revenue, growing capital, or a combination of both. Some mutual fund managers, especially those with long histories of consistent success, even reach minor celebrity status, like Cathie Wood and Peter Lynch.
Mutual fund investors own shares in proportion to the size of their investment. As with other investment vehicles, success is predicated on the rise in those shares’ value. Lynch’s Fidelity Magellan Fund — at one point the most successful mutual fund ever — grew over 29% while he was its manager between 1977 and 1990. The fund’s focus on large-cap tech stocks was perfectly timed with the breakthrough of online computing.
Although prototypes for mutual funds were around in the 18th century, the mutual fund as we now know it was created in the 1920s by an investment firm in Massachusetts. The Wellington Fund (VWELX), which arrived in 1929, was the first to balance stocks with bonds. It still exists today.
How Does Investing in a Mutual Fund Work?
A mutual fund’s share price is set according to its net asset value (NAV): the difference between the values of its assets and liabilities divided by the number of outstanding shares. The NAV is calculated once a day after the stock market closes for business, generally at 4 p.m. Eastern time.
Investors can order mutual fund shares any time of the day, but the transaction isn’t processed until the NAV is set. If you buy shares during daily trading hours, you get the shares at the end of the same day. If you place an order by that deadline, it’s official at the conclusion of the following business day.
With this process, mutual fund investors get a fair share price of the commodities the fund holds based on the complete market day. Unlike other vehicles like stocks or exchange-traded funds (ETFs) that are bought and sold in real-time, mutual fund share prices aren’t affected by multiple price movements throughout the day. This pattern corresponds to the long-term approach that mutual funds usually follow.
Advantages and Disadvantages of Mutual Funds
While there are many mutual fund benefits that inform their continued popularity, there are a few investment risks that may be problematic for some investors. Though many mutual funds are generally believed to be solid opportunities, each one has different focuses and management.
That’s why it’s worth taking a little time to study every mutual fund you’re considering for investment. What you may consider to be the advantages and disadvantages of mutual funds may be exactly the opposite for another investor with different priorities.
These pros and cons are generally — but not always — common to the generic mutual fund. The key is figuring out which advantages may not apply to your investor profile and which disadvantages may actually play in your favor.
Mutual Fund Benefits
Here are some of the most notable advantages of mutual funds.
Diversification
Perhaps the biggest benefit that mutual funds (and ETFs) provide is instant diversification. It’s probably the most-discussed stock tip in the entire business.
By investing in several different types of companies, business sectors, market caps, or other distinguishing factors, investors are better shielded against the risk of value loss. The thinking is that when a certain market segment is going through rough seas, another segment that is outperforming can balance out the loss.
Professional Management
Mutual funds are overseen by professional managers who work for financial firms like banks, asset management companies, brokerages, online investment platforms, and others. For some, mutual fund management is their full-time job.
The top managers have years of experience in their field. There are different rates of managerial involvement — compare mutual funds that are actively managed vs. index funds — but all are looked after and updated by financial caretakers.
Accessibility
Mutual fund investors can get in on the ground floor with a comparatively small amount of money. They get instant access to a diverse portfolio and usually don’t have to fork over a princely sum to do so. If all works out and the fund value grows, they can increase their investment levels as they go, but many get upfront coverage at a relatively inexpensive price.
Liquidity
Shares in mutual funds can be sold any day the stock market is in business. The daily price is set once a day, so you’ll always be clear on its current value. These sales convert to cash or its equivalent in short order, so they’re considered one of the more liquid investments you can make.
Potential for Compound Growth
Many mutual fund holders automatically reinvest the dividends and capital gains they earn back into the fund. This presents the possibility for compound growth, which can result in a sizable profit over the long term.
Regulation
The Securities and Exchange Commission (SEC) regulates mutual funds, which are accountable to their investors and must operate transparently. While it’s uncertain what regulatory changes may be afoot in the new presidential administration, there are safeguards in place to protect the investor class.
Some Possible Disadvantages
Even with the convenience and flexibility of mutual funds, they do present some potential risks to account holders.
High Fees
Professional management comes at a cost. Some mutual funds charge excessive fees with lopsided expense ratios and extra administrative charges. Over time, these charges can erode your profits — especially if the fund underperforms.
Underperformance
Not all mutual funds are expertly managed, and they can fall short of the success benchmarks that have been set. Extra fees and bad decisions can worsen the slack performance.
Tax Inefficiency
Capital gains distributions from mutual funds are taxable, even if they don’t sell any of their shares. This could lead to an unexpectedly high exposure to tax liability.
No Investor Control
Some investors prefer to be more hands-on with their decisions. Day-to-day operations for a mutual fund are entirely out of their control, and this can make investors a little nervous.
Commissions
Some mutual funds charge commissions — called sales loads — for transactions in a mutual fund. These can eat into the revenue from selling your shares and add extra cost to purchases.
Over-Diversification
While the right amount of diversification can mitigate risk, too much of it can water down your potential return on investment. This can blunt the impact of investments that are performing well in general.
Weigh the Pros and Cons
The advantages and disadvantages of mutual funds change from asset to asset. Take time and leave no stone uncovered when you’re researching different funds. Give yourself a pool of a few likely contenders to choose from. With the right combination of analysis and instinct, the merits and risks of mutual funds will come into clearer view.
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