Let us start off by understanding that mutual funds have several advantages and if we give due diligence before investing in any mutual fund; then we can expect decent returns on investment which are managed by professionals. Let us list down few of the most common advantages of mutual funds.
- Professionally Managed
- Risk reduction due to diversification of investment
- Fair pricing
- Automatic Dividend re-investment
- Small Investments
However there are several disadvantages, which we should be aware of while investing in any mutual fund.
- Over Diversification: Let us start our list of disadvantages with issue of over diversification. Idea of investment in mutual fund is associated with risk reduction due to diversified portfolio in comparison to investing in a single security; but over-diversification could reduce the return on investment below the expected return of the investor due to increased operating cost of the fund.
- Sub-Optimal Purchases: In continuation of the first point; when market is rising investor will be willing to invest more to gain from the uptrend. But this could actually result into sub-optimal buy as mutual funds managers has to invest the funds as per the guidelines and incase not many good securities available in a given sector then manager is forced to buy sub-optimal securities.
- Forced buy of costly shares: While market is rising and share prices are already high; new funds available will force the fund manager to buy shares at high, as fund manager cannot hoard money beyond certain limit.
- Forced sell at low prices: Rising market results into high liquidity; but if market is slowing down and share prices are falling then investors tend to take their money away from the mutual funds. This liquidity crunch can force fund manager to sell share cheaper; which can impact the over-all performance of the fund.
- Fluctuating returns: Mutual funds do not guarantee the fixed return and performance is always linked to market. Even professional management cannot guarantee the return in slowing market.
- No control over investment decision: Once we invest in mutual funds; we loose control over investment decision; as investment decision would be taken b fund manager and supporting analysts.
- Optimal Fund: While investing in mutual funds one of the biggest problems could be lack of understanding of mutual funds or not able to decide upon the mutual fund as per our investment goals. Unlike stocks, mutual funds do not offer investors the opportunity to compare the P/E ratio, sales growth, earnings per share, etc. A mutual fund’s net asset value gives investors the total value of the fund’s portfolio less liabilities, but how do you know if one fund is better than another?
- Expenses: As mutual funds professionally managed, thus investors are charged for services provided. Moreover certain mutual funds charge entry / exit load which is one time charge while investing or selling mutual funds. If a fund has an expense ratio of 1% and you have $10,000 in investment, the annual expense is $100. This is not too bad. However, if you have $250,000, the annual expense is $2,500 — that’s a lot of money.
- Lock-in periods: Many mutual funds have long-term lock-in periods, ranging from 5 to 8 years. Exiting such funds before maturity can be an expensive affair.
In addition to above mentioned disadvantages there are several other problems, like:
- Misleading Advertisements: The misleading advertisements of different funds can guide investors down the wrong path.
- Past performance: Ratings and advertisements shown by mutual funds are indicator of past performance which might not be replicated in future.
- Survivor ship bias: Mutual funds tend to show performance of funds which have survived through market downturn but does not give any information regarding investments which resulted into losses and closed down during that period.
- Fund Managers: Mutual funds tend share information about star performers but even good fund managers cannot guarantee the good returns in long term or market downturn.
Conclusion: While making any investment it is always advisable to take informed decisions. Even best of the mutual funds cannot guarantee stable returns over long term period.