Pros and Cons of Investing in Mutual Funds

Mutual funds are a popular investment choice for individuals seeking diversification and professional management without the burden of selecting individual stocks or constantly adjusting their portfolio. By pooling money from multiple investors, these funds invest in a mix of assets — such as stocks, bonds or both — tailored to specific goals and risk preferences. With thousands of mutual funds available, finding the right one takes thoughtful evaluation and research. It helps to begin by weighing the pros and cons of investing in mutual funds to determine which type of investment strategy most makes sense for you.

You can consider working with a financial advisor to guide you through the world of mutual fund investing.

What Is a Mutual Fund?

A mutual fund is a professionally managed investment portfolio composed of one or more asset classes. Think of them as baskets of stocks, bonds, commodities, real estate investments and more. 

Mutual fund managers generally determine their asset mix based on a particular investment objective. For instance, a mutual fund that aims for long-term growth may invest entirely in stocks and high-yield bonds.

However, purchasing shares of a mutual fund is different from buying shares of individual stocks and bonds. When you buy shares of a mutual fund, your money is pooled with that of others who invest in the same fund. Therefore, your return is based on the fund’s performance and the proportion of its shares you hold.

Investors may also note that these pooled investments can offer more diversification than other financial investments, such as exchange-traded funds (ETFs). Since mutual funds invest in a variety of securities, the risk is spread across multiple assets. This reduces the impact of any single security’s performance on the overall performance of the fund. However, mutual funds are subject to market volatility, which means that the fund’s value can drop during economic downturns or financial crises.

It is also important to know that mutual funds trade once a day. Their share prices are based on their net asset value (NAV) and computed when markets close each day. The NAV equals the total value of portfolio assets (minus any liabilities) divided by the number of outstanding shares. 

However, you cannot always purchase just one mutual fund share. Most mutual fund companies require minimum investments that typically stretch from $500 to $5,000, but requirements depend on the exact fund you choose.

Pros and Cons of Investing in Mutual Funds

Mutual funds offer a number of benefits that make them an attractive investment option for many individuals. One major advantage is dividend potential; investors can receive dividend payments from the fund, which may be reinvested to help accelerate portfolio growth.

Mutual funds also offer built-in diversification by spreading investments across a range of assets, helping to reduce risk. They are generally easy to access and understand, even for beginners, and are managed by professional portfolio managers who make decisions on behalf of the investors.

However, mutual funds also come with drawbacks. Investors have limited control over tax timing and may be subject to capital gains taxes when the fund makes distributions. Additionally, mutual fund trades don’t execute in real time, which can slow down buying or selling compared to individual stocks.

Some funds carry high expense ratios, particularly those above 1.50%, that can eat into your returns over time. There’s also the risk of poor fund management, including excessive trading or questionable end-of-quarter activity designed to improve short-term appearances.

Types of Mutual Funds

It’s important to note that the market currently houses more than 7,000 mutual funds, each with its own asset allocation, objective and investment strategy. 

These are the most common types of mutual funds and how they work.

• Stock funds: These funds invest in shares of different companies. Some stock funds focus on investing in companies of a particular market capitalization. This is the total dollar value of a company’s outstanding shares. Large-cap, for example, defines companies with more than $10 billion in market capitalization. Generally, these are well-established firms. Investing in small-cap companies, on the other hand, may involve more risk.
• Bond funds: These funds focus on fixed-income securities and pay interest to their shareholders on a regular basis. These funds may hold different types of debt instruments, such as government, municipal or corporate bonds. The bond fund typically distributes interest payments monthly based on the underlying bonds in the mutual fund. That means the income can change across different payment periods.
• Balanced funds: These funds invest in a mix of stocks, bonds or other securities. Managers typically keep a fixed asset allocation based on the investment strategy of the fund. This can range from conservative to aggressive, depending on the fund’s objective.

How Do Mutual Fund Fees Work?

Large fees can make a major dent in mutual fund returns. In fact, one of the downsides of investing in mutual funds is their complex fee structures. Oftentimes, the extent of fees involved with mutual funds depends on the fund’s management strategy.

1. Expense Ratios

First, each mutual fund charges an annual expense ratio to cover overall operating and management expenses for the fund. Expense ratios usually range from 0.5% to 1.5% and are generally calculated as a percentage of the income that the fund generates. Thus, your account would face its proportional share, reducing your overall assets.

Additionally, some mutual fund expense ratios include 12b-1 fees to cover marketing and promotional costs. Under the law, this particular component cannot exceed 1%.

The amount that comes out of your account to cover the expense ratio is not explicitly detailed in your statements. However, you can get a good glimpse of what you are paying indirectly for fund expenses if you multiply the expense ratio by the average balance invested in a 12-month period. 

2. Load Fees

Mutual funds may also charge load fees when you buy or redeem shares. These fees are separate from the fund’s expense ratio. 

Load fees cover commissions paid to brokers and others involved in mutual fund transactions. These can span from 4% to 8% of your investment but cannot be more than 8.5%. Some mutual funds charge front-end loads, which are deducted from your initial investment when you purchase shares.

Other funds charge back-end loads when you sell your shares within a defined time span after you purchase them. Also known as deferred sales charges, these fees generally decrease the longer you hold onto your shares until the fee disappears. For instance, the back-end load may start at 6% if you redeem your shares within a year after purchase. It can then go away after you hold on to those mutual fund shares for six years.

Active vs. Passive Mutual Funds

An actively managed mutual fund aims to outperform the market. The fund manager will likely utilize a wealth of research and analysis theories to build a mutual fund with specific securities that are expected to make substantial returns. It may undergo several transactions in the process. Of course, all this takes money, so active funds tend to charge large expense ratios and loads due to the complex management activity.

Passively managed funds, however, tend to track an index of different securities, such as the S&P 500. This consists of the top 500 U.S. companies with the biggest market capitalization. In other words, the fund aims to mimic the overall return of the S&P 500 by investing in securities that already exist within the index. Therefore, it tries to copy the market rather than beat it. 

As you can see, this strategy strips away much of the careful selection involved with active management. As a result, passively managed funds generally charge lower fees than their active counterparts.

While beating the market certainly sounds more lucrative than simply mirroring it, several studies indicate that actively managed funds rarely accomplish their overall goals. However, actively managed funds may be able to better hedge against risk due to their tendency to buy and sell securities when deemed necessary.

Finding the Best Mutual Funds

Some firms like Morningstar conduct extensive research on mutual funds. They can provide crucial data on a fund’s asset allocation and investment strategy, as well as manager bios. Such firms will also rate mutual funds according to multiple factors, including performance.

You can also find a lot of this information laid out in the fund prospectus. This document delineates key information about a mutual fund, such as its fees, expenses, asset allocation and objectives. 

While researching potential mutual funds to invest in, good indicators may include the following:

• A management team that has run the mutual fund for a long time
• Successful long-term performance record (but keep in mind this is no guaranteed indicator of future performance)
• Low fees compared to similar funds

Interestingly, a Morningstar study suggests that low fees may be the best predictor of mutual fund performance.

When Are Mutual Funds a Good Fit for Your Portfolio?

Mutual funds can be well-suited for investors looking for simplicity, diversification and long-term growth without the burden of managing individual securities. They are often ideal for retirement accounts, such as IRAs or 401(k)s, where the focus is on broad market exposure and tax-deferred growth over decades. In this context, mutual funds provide an easy way to invest in different asset classes with limited oversight required from the investor.

They also make sense for individuals who prefer a hands-off approach or lack the time or expertise to actively manage a portfolio. Investors seeking exposure to professionally-selected securities, whether through active or passive management, may find that mutual funds offer a balance of convenience and oversight. Additionally, mutual funds may be beneficial for those contributing to long-term savings plans, education accounts or income-generating portfolios.

However, mutual funds may not be the best fit for tactical investors, short-term traders or those prioritizing intraday control or ultra-low-cost investing. In such cases, exchange-traded funds (ETFs) or individual securities might offer more flexibility and real-time trading capability. 

Ultimately, mutual funds are best used as core holdings in a broader strategy, especially for investors with long-term goals and a preference for steady portfolio construction.

Factors to Consider Before Investing in Mutual Funds

When determining whether a mutual fund is right for you, your financial situation and your investment goals, there are several things to consider. 

• Your investment goals: Whether you’re looking for growth, income or capital preservation, be sure to identify your financial goals. Different mutual funds focus on various strategies, such as equity funds for growth, bond funds for income or balanced funds for a mix of both.
• Risk tolerance: Mutual funds vary in risk levels. Equity funds, particularly those focused on smaller companies or emerging markets, tend to have higher volatility compared to bond or money market funds.
• Expense ratios and fees: Mutual funds come with fees, which can include expense ratios, management fees and sales charges (loads). Lower-fee funds tend to outperform higher-fee ones over the long term, as fees can significantly impact returns.
• Performance history: While past performance doesn’t guarantee future results, it is still worth examining a fund’s long-term track record to assess its consistency over time. Look for performance over at least five to 10 years, but do not rely solely on short-term trends.
• Fund manager and strategy: Consider the experience and reputation of the fund manager. Active funds rely on the manager’s expertise to beat the market, so researching their track record and investment approach is important. Passive funds, like index funds, track a specific market index and usually have lower fees.
• Minimum investment requirements: Many mutual funds have minimum initial investment amounts, which can range from a few hundred to several thousand dollars. Make sure the fund’s minimum fits within your budget.
• Tax efficiency: If investing in a taxable account, consider the tax implications of the mutual fund. Some funds are more tax-efficient than others, distributing fewer capital gains, while others may generate higher tax liabilities.
• Liquidity and redemption policies: Most mutual funds offer liquidity, allowing you to redeem your shares easily, but some may have restrictions or redemption fees for early withdrawals. Ensure the fund’s liquidity meets your needs, especially if you may need access to your funds quickly.
• Dividend and distribution policies: Some mutual funds pay out dividends or distribute income regularly, which can be an important source of cash flow for income-focused investors. Others may reinvest earnings within the fund. Know how the fund handles distributions and how that fits with your income needs.

You can also consult with a financial advisor before making a decision. 

Bottom Line

Investing in mutual funds offers the advantage of professional management, eliminating the need to pick individual securities. Fund managers curate portfolios with specific growth objectives, but investors must still research their options. With a wide range of funds — stock, bond or balanced — it’s crucial to assess fees, asset allocation, objectives and the fund managers’ track records before investing. Be sure to carefully weigh the pros and cons of investing in mutual funds to ensure they are a right fit for you based on your short-term and long-term goals.

You can also work with a financial advisor to develop a financial strategy that incorporates mutual funds for a more diversified investment portfolio.

Tips on Mutual Fund Investing

• Because of the complexity of mutual funds, it can be a good idea to seek the guidance of a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area. You can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Mutual fund fees can take huge chunks off your returns, which is why you should research investing costs with laser precision. But one good place to start might be with index funds. These passively managed funds generally charge lower fees than actively managed ones.

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