What are the advantages and disadvantages of mutual funds?
Please also explain the basics on them.
Answers | 2
First, the basics: A mutual fund is a pooled investment vehicle. You and other investors pool your money with a professional money manager who then invests these funds according to a specific approach or style outlined in a disclosure document referred to as a prospectus.
For someone with little capital to invest or little time to do research on specific stock and bond issues, using mutual funds may help because they offer diversification and professional management in a convenient package. There are few other options available where an investor can with as little as $25 per month get a piece of the stocks or bonds of dozens or even hundreds of companies.
The money manager may invest in stocks or bonds or other regulated investments. Some money managers invest broadly in a range of investments. Others may focus on specific industries or sectors. Investments may be made just in the US or globally or in just one foreign country.
Some managers actively research and screen to find stocks or bonds that they think will appreciate and try to actively "beat" their market index. Others subscribe to a more passive approach buying stocks or bonds that track an index and ignoring the day-to-day changes that may occur in the markets. By their very nature, these types of funds are not designed to "beat" the market.
So the advantages of a mutual fund are getting professional money management along with diversification in a quick and easy way. You also may benefit from the skill of the money management team and its research resources it uses to find opportunities or avoid certain market risks.
The disadvantages of a mutual fund are that you have little say in the actual investing. If you don't like the way things are going, you can vote with your wallet and redeem your shares and move your money into another investment vehicle.
There are risks to investing. There is the risk that comes with fluctuations in the value of the investments throughout the day. There is the risk that the underlying companies chosen by the mutual fund team may go into default. There is the risk resulting from changes in interest rates. While this will more directly impact the value of bonds, interest rates also affect the valuation assumptions of stocks, too.
But these risks are not specific to just mutual funds but affect investments generally. The only way you can mitigate your risks is not investing in the markets at all but that still means your capital is at risk from the impact of inflation on how much your money can buy in the future.
The more specific disadvantages associated with mutual funds are: expenses, taxes and control.
Expenses: There's no free lunch. Professional management, marketing and research staffs cost money. Some are better at it than others and costs may be less. For mutual funds following a more plain-vanilla style or sector, the costs may be lower because of competition. For others investing in specialty areas, the costs may be dramatically higher. But in almost all cases, actively managed mutual funds have costs that are higher than passively-managed index funds. And unfortunately, as the mutual fund industry has grown there has not been a clear reduction in expenses one might expect from the economies of scale of some of these managers (i.e. it doesn't cost any more to invest the $1 billionth dollar than it does for the $1 millionth). And you may pay a sales charge for the purchase or redemption of your mutual fund units. Unless you choose to go the "no load / no commission" route this charge may range up to 6% for Class A shares down to zero for Class C shares but with a higher internal expense cost (up to 1% per year) to compensate the stock broker or registered rep who sold you the investment.
Taxes: As a pooled investor, you have no control over how gains and interest are distributed to you. In fact, mutual funds are required to pass along their gains to investors to maintain their tax-advantaged status. So it's not impossible for an investor to receive a 1099 for them to declare capital gains even if the value of the funds may have dropped.
Control: Mutual funds are structured so that you can buy or sell based on the closing price (known as the Net Asset Value) calculated from the proportionate share of the fund you own and all its underlying holdings. If you want to sell, you have to place your order but you won't know the value until the close of business. For those investors looking to have more control over their investing strategies or their taxes or to react to market conditions, then investing in individual stocks or bonds or Exchange Traded Funds may be a better fit.
Advantage - Easy Diversification. You are able to purchase one fund and gain exposure to hundreds or thousands of stocks.
Disadvantage - Cost. Mutual Funds can provide you diversification benefits described above but they charge for that service.
I hope this helps!