Mutual funds: Pros and cons for investors

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, though they’re by no means perfect.

Here are the key advantages and disadvantages of mutual funds  and whether they may be 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. A professional fund manager buys and sells securities in line with the goals of the mutual fund. So instead of investing in many different individual companies, investors can simply buy shares in the mutual fund. All the hard work of choosing investments is done behind the scenes by the fund manager.

Many different types of mutual funds are available, depending on what you want to invest in and even how long you want to invest. For example, some funds invest in virtually the entire market or some section of the market such as a fund based on the S&P 500 index or a specific industry. If you need your money at a specific point in the future, such as retirement, a target-date fund can offer a solution that helps reduce your risk.

Most mutual funds charge an expense ratio, a fee that covers the fund’s operating expenses (administrative costs, marketing and salaries) and provides a profit for the fund managers. This fee is a percentage of the total assets you invested in the fund. In addition, some funds have what is called a sales load, which is a commission. Fortunately, many high-performing funds today do not charge a load, and it’s easier than ever to find them and avoid that needless fee.

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

Mutual funds have several advantages  that have led to their widespread popularity, including convenience, professional management, and diversification. If you want to know how to pick the best mutual funds, look for them to hit on all of these points.

Attractive returns

The best mutual funds can return 10-12 percent in an average year over time, while in their best years a top mutual fund can return 20 percent or more. Funds that are based on the S&P 500 are among the best long-term performers.

Convenience

Mutual funds make it 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 can fund your employer-sponsored retirement plan with a payroll deduction so your retirement account grows out-of-sight, out-of-mind.

Low fees

Some top mutual funds have expense ratios of just 0.03 or 0.04 percent annually of your invested assets. That translates into an expense of just $3 or $4 for every $10,000 you have invested. That’s tremendously cheap and keeps more of that money working for you. Low-cost funds are usually passively managed index funds rather than actively managed funds.

Some mutual funds even come without an expense ratio. Fidelity Investments introduced its line-up of no-fee funds in 2018, and it offers a clone of the S&P 500 (without calling it that) in its Fidelity ZERO Large Cap Index Fund (FNILX).

While mutual funds may be low cost, many of them do have high fees, so tread carefully.

Built-in diversification

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. So, they can have strong performance without excessive risk.

Some of the largest mutual funds, such as the Fidelity 500 Index Fund (FXAIX), Vanguard 500 Index Fund (VFIAX) and the Vanguard Total Stock Market Index Fund (VTSAX), are index funds. These funds aim to track the performance of an index, such as the S&P 500, which contains hundreds of America’s top companies, providing a lot of diversification.

Professional management

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.

With a passive investment strategy, such as with index funds, the fund tracks a specific index, such as the S&P 500 or the Nasdaq Composite. In contrast, an active investment strategy uses investment analysts to try to find stocks that will outperform a benchmark index. Passive strategies tend to do better than active strategies, in part because they have lower expenses.

Dividend reinvestment

Another benefit of mutual funds is that any cash dividends can be automatically reinvested. For example, if a mutual fund pays out dividends or capital gains, that money can usually be reinvested without any fees.

Disadvantages of mutual fund investing

Although mutual funds have many advantages, they have a few key disadvantages, too.

High fees

While mutual fund fees have come down a lot over the last decade, fees can still 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 investors tens or even hundreds of thousands of dollars in their lifetimes. On top of that, the broker may charge you a sales load 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. The best brokers for mutual funds allow you to buy and sell funds with no commission.

Conversely, there are many index funds available with low fees or no fees at all, allowing investors to build portfolios with a few funds for a 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, and 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 traded only once per day 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?

In many cases it makes sense for individuals 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 free money likely outweighs most negatives of mutual funds.

But plenty of mutual funds remain popular outside employer-sponsored retirement plans, too. For instance, popular Vanguard funds such as the Vanguard 500 Index Fund (VFIAX) and the Vanguard Total Stock Market Index Fund (VTSAX) have low fees and are tax-efficient – just 0.04 percent, as of this writing.

If you’re a beginner, mutual funds could be a good match as you get started.

Are mutual funds better than stocks?

It’s important to remember that mutual funds are not the asset you’re investing in, but rather are the vehicle for investing in assets such as stocks and bonds. Many people use mutual funds to invest in stocks as a way to simplify the investing process and access a diversified portfolio with professional management. If you invest in a stock mutual fund, the performance of the fund can only be as good or bad as the performance of the underlying stocks held by the fund.

Can you lose money in a mutual fund?

Just as with any investment, you can lose money in a mutual fund. If the investments held in the fund decline, the mutual fund itself will also lose value. The mutual fund holds the assets that you’re investing in and its performance will depend on the performance of those stocks or bonds. Mutual funds that track broad market indices such as the S&P 500 have strong long-term track records, however. Investors in these funds have earned about 10 percent annually over the long-term.

Bottom line

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. But mutual funds have their quirks, including high fees and sales commissions, and they can only be traded once per day. But you can mitigate the worst of these issues by carefully selecting your mutual funds and looking for low-cost options.

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.