A mutual fund is one of the common types of an investment fund or pooled fund that combines money from different investors to mutually buy a variety of securities and asset classes like stocks or equities, debentures or bonds, derivatives, and even other pooled funds like exchange-traded funds and real estate investment trust. Most novice investors are invested in mutual funds and even experienced ones believe in the benefits of investing in these pooled funds. Nevertheless, when it comes to deciding whether or not this option is a suitable investment decision, it is also important to understand further the advantages and disadvantages of mutual funds as a whole.
Pros of Mutual Funds: Notable Advantages and Applications
There are several benefits to investing in mutual funds as opposed to investing in individual securities. The general advantage centers on convenience. There are also more specific advantages. Take note of the following:
1. Investment Diversification and Risk Management
One of the defining advantages of mutual funds is that they provide an easier avenue for investors to diversify their investments and manage risks associated with limited investments or smaller investment portfolios. It is important to note that a particular fund represents a basket of different investments. This means that investing in a single fund also means investing in different securities in a single transaction and a single account.
2. Varied Selection of Funds with Specific Objectives
There are different classifications of funds. These classifications are based on their principal investments. These include money market funds, fixed-income or bond funds, stock or equity funds, and hybrid funds or balanced funds, among others. Some are industry-specific. Each classification has its predefined investment objectives and caters to the varied and personal goals and objectives and risk profiles of each investor.
3. Affordable Investment From Economies of Scale
It is also more affordable to invest in mutual funds than to buy individual stocks, bonds, or other types of securities. An individual can open an account for as low as USD 10.00 or USD 100.00 The low entry point comes from the fact that monies are pooled from other investors to allow the purchase of varied securities. A mutual fund takes advantage of economies of scale to transact in large volumes and lower transaction costs.
4. Professional Fund Management and Transparency
Another advantage of mutual funds is that investing in them comes with professional management. There are fund managers responsible for researching, selecting, and managing the underlying investments. This saves an individual time and effort compared to self-directed and active investing and trading activities. Mutual funds are also transparent because they are required to disclose their holdings and performance regularly.
5. Income Generation or Capital Growth and Liquidity
Some mutual funds are income-focused while others are growth-focused. Income-focused funds invest in dividend stocks, bonds, or both to generate regular income for their investors. Funds that are growth-focused prioritize long-term capital appreciation growth either through holding, reinvesting earnings, or both. All mutual funds are also structured to enable ease of liquidation. Most of them can be bought or sold on weekdays.
Cons of Mutual Funds: Key Disadvantages and Limitations
It is important to note that the performance of mutual funds is dependent on several factors. An investment in a particular fund does not guarantee considerable amounts of returns. The following are the specific disadvantages:
1. High Expense Ratios and Other Investment Costs
Mutual funds tend to have a higher expense ratio than exchange-traded funds. These expenses cover the costs of managing the funds. More specific examples of these costs or fees include management fees, administrative fees, and operational expenses. These can reduce the overall return on investments. Actively managed funds like those that regularly change or adjust their holdings have higher fees than passively managed funds.
2. Lack of Control and Decisions Over the Investments
Another disadvantage of investing in mutual funds is that investors do not have control or direct decisions over their investments. This is true for all pooled funds. Professional fund managers are responsible for making decisions that include the selection of holdings and allocation to different securities. These managers are professionals but it is also possible that their decisions may not always align with individual goals and objectives.
3. Exposure to Different Types of Investment Risks
All investments have risks. The level of risk varies and is dependent on the particular securities or assets. Nevertheless, when it comes to mutual funds, the risks can also vary. An equity fund is exposed to the common risks associated with stock investing. These include market risk, business cycle risk, and interest rate risk A fixed-income or bonds fund shares the risks of bond investing such as credit risk, liquidity risk, and inflation risk.
4. Missed Opportunities From Poor Trade Execution
Funds that are actively managed suffer from poor trade execution. The underlying securities of these funds are typically traded once a day at the close of the market. The prices of these funds are based on their Net Asset Value or NAV which is calculated after the market closes. This trade execution scheme often results in missed opportunities from intraday price movements and an NAV that reflects that overall market conditions at close.
5. Potential for Underperformance and Poor Results
Furthermore, because of the poor trade executive actively managed mutual funds are not able to maximize the full potential of the underlying securities. Funds like equity index funds that attempt to follow or outperform the market average do not always succeed. A fund can suffer from diluted returns from better-performing securities if it is overdiversified or holds an extensive selection of securities. The returns can be unpredictable too.
Reminders: Considerations When Investing in Mutual Funds
The aforementioned disadvantages of mutual funds should not deter one from investing in them or adding a particular fund as part of his or her overall investment portfolio. Take note that the advantages of mutual funds are still appealing for first-time investors, those with limited budgets, or individuals with no time to select and monitor individual securities.
Nevertheless, when it comes to deciding to invest in mutual funds, it is important to understand also the different types of funds, the different avenues or platforms where these funds can be purchased, and make sure that the selected fund is aligned with the investment goals and objectives, risk tolerance, and investment time horizon of a particular investor.
