Advantages and Disadvantages of Mutual Funds

The sheer ease of access with mutual funds investments drives much of the wide participation that we see with these funds. The majority of individual investors simply lack the knowledge and sophistication to become involved in any real capacity on their own.

This takes at least some initiative and motivation and a lot of people simply do not have the time or the confidence to spend even exploring what the options may be for them in any great detail.

Advantages and Disadvantages of Mutual FundsSo, their investment advice is pretty much relegated to their bankers or other advisors, who are in the business of selling mutual funds. If you visit a mutual funds store, it should be no surprise that people walk out with mutual funds in their shopping bag.

Although the quality of this financial advice does differ, for the most part, these people’s ultimate role is to make take direction and make money for their employers, and although they often will make recommendations with your best interests at heart, these decisions are still made from within the scope of choosing from among the various products that they sell.

With this all said though, the type of investments they promote will often be the right ones for the client, at least as far as their investing in mutual funds versus some other type of investment. The options can be very limited here, and if someone does not have the desire to make their own trading decisions, but still want to take on at least some risk in order to shoot for returns exceeding the rate of inflation, and also want a good amount of diversity, mutual funds may be the only good choice here.

Mutual Funds Almost Always Win Out by Default

Prior to the popularization of mutual funds, a lot less individual investors were active in the market, and relied a whole lot more on savings than active investments. Those of means had full service brokerages manage their investments for them to some degree, although the quality of the advice did not tend to be first rate, and these portfolios usually lacked the diversity that keeps people from being exposed to too much risk.

Even this does require a good-sized portfolio, and while many investors may get there over time through sound management, if you need this size to get in the door, you won’t get there this way. The fees involved in getting full service individual financial advice is on the higher end as well, as would be expected, and this is one of the reasons why this does not make sense for a lot of investors.

Mutual funds, on the other hand, do not suffer from issues of accounts being too small, and these accounts can be opened for even very small amounts. While there are significant costs to operate the funds, the costs are spread across a great many clients and a very large amount of invested capital, such that the costs involved can be assessed on a per dollar invested basis, consisting of a few percentage points per year.

This is how mutual fund fees are often structured, and although there are a variety of different ways that mutual fund fees are assessed, one not need put any money up front or have any fixed costs whatsoever in order to invest in them. This makes mutual funds particularly attractive to those with small amounts of money to invest and especially those who enjoy the simplicity that no load funds provide.

So, the main benefit with mutual funds is really just the fact that they are so accessible, to the extent that anyone who wants to invest in the markets can be readily accommodated in a mutual fund.

Since mutual funds are offered for sale at just about any financial institution, all one needs to do in order to start a mutual fund is to show up and ask for one, and setting up these funds then becomes a simple and fairly quick process. It doesn’t get much easier than that.

Mutual Funds Are Very Flexible and Customizable

Aside from the benefits of the ease and the fact that just about anyone with even a few bucks to invest can be accommodated by mutual funds, they also are quite customizable, in spite of the fact that these funds are all designed with large groups of investors in mind.

Even though that is the case, the sheer number of people who invest in mutual funds allows for a wide diversity of different funds out there, where one can then combine investments in various ones to seek to achieve one’s particular investment objectives.

Not only can one invest in a mutual fund with very little money to start, one can also invest in a portfolio of mutual funds. For instance, if someone is looking for a certain combination of stocks and bonds, they can combine one or more stock funds with one or more bond funds to achieve the desired result.

Different types of each asset class can be combined together in a portfolio to seek a certain exposure to these certain types, for example someone may want a certain percentage of their stock portfolio in growth stocks or stocks in a certain industry and another percentage in blue chip stocks or ones that pay higher dividends or whatever one wishes.

There is a lot of flexibility here to tailor one’s portfolio to whatever most suits the investor, and this can serve to increase the amount of diversification within asset classes like stocks or bonds. Advisors are there to suggest what sort of allotment makes sense based upon an investor’s time horizon, tolerance and preference for risk, the sort of returns that an investor seeks, and anything else what may shape the decision.

Some Potential Downsides of Mutual Funds

Since mutual funds are sold by dealers, they do have an interest in the matter, and usually aren’t acting wholly in the clients’ interest. While they are subject to rules that do serve to protect investors from being exposed to more risk than the guidelines suggest, there is nothing in there to guide dealers and their representatives from selling a client a mutual fund investment when another strategy may be more appropriate.

While potential investors are asked questions in order to base the recommendations on, there is a fair bit of latitude in the interpretation of these answers, and therefore some investors may see themselves exposed to more risk than they actually end up being comfortable with later.

An example of the negative consequences of this is when you see investors exit their positions in down markets merely due to their risk tolerance being exceeded, even though there was not the original intention to hold the funds for such a short duration.

This can work the other way as well, as some investors may not be permitted by the guidelines to take on the amount of risk they prefer, and may have to settle for more conservative investments than they are seeking. This does impact things as well and it’s not always just about keeping risk down.

Guidelines for selling mutual funds tend to be more defensive than aggressive though, and a big part of this is the dealer looking to minimize complaints like their agent sold someone a fund that ultimately was too risky for the client.

Mutual Funds’ Objectives Aren’t Always Well Aligned with Investors’ Objectives

Mutual funds, partly by their nature, tend to focus a lot on the longer term, and therefore aren’t always suitable for those who wish to take on additional risk but are looking to hold for shorter lengths of time than mutual funds are set up for generally.

If, for instance, you’re only looking to invest for a year or two in a fund, if the fund is holding their assets in a longer time frame than this, which they usually do, then one’s investments may end up being exposed to more or even quite a bit more risk than they should.

One could just sell the funds when things start going the wrong way, but when the objective of a fund and an investor’s objective is not aligned, this is not idea, as you really don’t want your investments to be managed in a different way than you would like them to be.

So, you may see a case where the market is in a downward trend and the expectation is that it will probably reverse and recover over a number of years, but if the client is not prepared to ride this out, staying in the fund doesn’t make sense. It also really doesn’t even make sense for the person to invest in this at all, but this market is underserved by the mutual fund industry and one is left to simply trade them to seek their objectives.

This may seem reasonable but goes against what mutual funds are all about, having a professional team manage one’s investments according to one’s objectives, not just theirs.

Mutual funds are traded in very big amounts due to their size, and this is certainly a disadvantage compared to trading much smaller sizes. This places a lot of limitations upon what a mutual fund can do, compared to what one could do on their own.

This includes things like trading instruments that don’t have a huge amount of volume, as well as getting in on a lot of things that mutual funds aren’t allowed to do, like going short, or mixing in  other types of instruments such as forex or derivatives.

Making one’s own investment or trading decisions just isn’t something that many investors are up for, and at the best of times this involves a trade off with diversification. Most of the risk involves market risk though and this is something that individuals can at least potentially manage better, getting out of the market or even shorting it should conditions warrant.

All things considered, mutual funds are a great idea which does allow a lot more people into the market, people who would not otherwise dare to invest, and it certainly does add a lot to the volume of markets, which is something that benefits us all generally.

Ken Stephens

Chief Editor,

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: [email protected]

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