Mutual funds are one of the most popular ways to invest. There are trillions of dollars invested in mutual funds worldwide, offered by well-known asset managers such as BlackRock, Vanguard, State Street Global Advisors and more. Mutual funds come with a number of advantages, so it’s no surprise there is so much money invested in them.
However, mutual funds are by no means perfect. Their fees can sometimes be high, creating a drag on overall returns. This is just one of the disadvantages, however. In this article, we will walk through the key advantages and disadvantages of mutual funds at length to help you decide if they are the right type of investment for you.
Mutual funds: An overview
Mutual funds are a type of investment fund that allows investors to pool their money. Then, a professional fund manager buys and sells securities in line with the goals of the mutual fund. Instead of investing in many different individual companies, investors can simply buy shares in the mutual fund. All the hard work is done behind the scenes by the fund manager.
There are many different types of mutual funds available, from target-date funds to total-market index funds. Most mutual funds have some type of fee, be it in the form of load fees or operating expenses. These fees cover administrative costs, marketing and fund manager salaries, among other items.
The relative ease of investing in mutual funds has made them wildly popular, and many U.S. companies offer mutual funds as part of a 401(k) plan. But should you invest in mutual funds? Let’s dig into their advantages and disadvantages.
Advantages of mutual funds
There are several advantages of mutual funds which have led to their widespread popularity. Convenience, professional management, and diversification are some of the biggest advantages. If you want to know how to pick the best mutual funds, look for them to hit on all of these points.
Mutual funds make it very easy to invest. You can hold them in a number of different accounts, including employer-sponsored retirement accounts, an individual retirement account (IRA), or in a brokerage account. All you’ll have to do is place an order for the number of shares you want to buy and wait for the order to be filled at the end of the day.
You can usually automate this process, buying a set number of shares on a regular schedule, such as every two weeks. To make things even easier, you may be able to fund your employer-sponsored retirement plan with a payroll deduction so your retirement account grows out-of-sight, out-of-mind.
Mutual funds have built-in diversification, making them a less volatile investment. They invest in a large number of companies, greatly lessening the impact of any one company performing poorly or even failing. Thus, they tend to have strong performance without excessive risk.
Some of the largest mutual funds, such as FXAIX, VFINX and VTSAX, are index funds. These funds aim to track the performance of an index, such as the S&P 500.
When you invest in a mutual fund, you don’t have to worry about constantly buying and selling securities. Instead, the fund manager does all of the work for you. If you automate your investment strategy, there will be very little time spent managing your portfolio.
Another benefit of mutual funds is profit reinvestment. For example, if a mutual fund pays out dividends or capital gains, that money can usually be reinvested without any fees. And this can all be done without any input from the investor.
Disadvantages of mutual fund investing
Although mutual funds have many advantages, they have their share of disadvantages, too.
One issue many holders of mutual funds face today is high fees. While mutual funds do quite a bit to help their investors, fees can be excessive in some cases. Some mutual funds have expense ratios of 1 percent or more. That may not sound like a large percentage, but it can cost some investors tens or even hundreds of thousands of dollars in their lifetimes. On top of that, the broker may charge you to buy or sell the fund, and some fund companies even hit you with a commission that could be 1 or 2 percent of the total investment, or what’s called a sales load.
Conversely, there are many index funds available with very low fees or no fees at all, allowing investors to build portfolios with a few funds for a very low cost.
Uncontrollable tax events
Investors don’t have to worry about buying and selling securities all the time when they invest in mutual funds. That usually means a lot less work is needed from the average investor. But when a mutual fund sells securities from its portfolio, it may lead to year-end distributions to investors. These distributions are taxable investment income.
These distributions are taxed at either ordinary income rates or capital gains rates, depending on how long the fund held an investment, which means you might be left with a higher-than-expected tax bill at the end of the year. Those in high tax states may want to pay special attention to this issue, since it can eat away at your gains.
No intraday trading
Unlike stocks and exchange-traded funds (ETFs), mutual funds are only traded once per day. That happens after the market closes at 4 p.m. Eastern time. While this is not a huge problem for passive investors, it could mean there is a different order price than you expect if you place orders manually.
Who should invest in mutual funds?
There are many cases in which it makes sense to invest in mutual funds. For instance, your employer-sponsored 401(k) retirement plan may offer a selection of mutual funds. Often these funds are lower-cost versions of widely available funds, and you won’t pay trading fees or endure the tax bite of capital gains distributions in a 401(k), as you would in a taxable account.
So investing in mutual funds through your employer may be a good idea, particularly if an employer match is offered. This is free money and something that likely outweighs any negatives of mutual funds.
But there are plenty of mutual funds that remain popular outside employer-sponsored retirement plans, too. For instance, popular Vanguard funds such as VFIAX and VTSAX have very low fees and are tax-efficient.
If you’re a beginner, mutual funds could be a good match as you get started.
The best mutual funds allow individuals to invest in a professionally-managed investment portfolio with built-in diversification. This makes them convenient, especially since investors don’t have to worry about buying and selling securities. Dividends and capital gains can be reinvested automatically, allowing investors to fully-automate their strategy. Plus, mutual funds are often offered through employer-sponsored retirement plans, allowing an employer match and payroll deduction.
But mutual funds have their quirks. Some mutual funds come with high fees and sales commissions, and they can only be traded once per day. But you can avoid, or at least mitigate, the worst of these issues by carefully selecting your mutual funds and looking for low-cost options.
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Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.