Mutual funds are considered relatively safe investments. However, mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high expense ratios charged by the fund, various hidden front-end, and back-end load charges, lack of control over investment decisions, and diluted returns.
Key Takeaways
- Mutual funds are largely a safe investment, seen as being a good way for investors to diversify with minimal risk.
- But there are circ*mstances in which a mutual fund is not a good choice for a market participant, especially when it comes to fees.
- Fees include a high annual expense ratio or the amount the fund charges its investors annually to cover the costs ofoperations, and load charges, or a fee paid when an investor buys or sells shares of a fund.
- Mutual funds are managed and therefore not ideal for investors who would rather have total control over their holdings.
- Due to rules and regulations, many funds may generate diluted returns, which could limit potential profits.
High Annual Expense Ratios
Mutual funds are required to disclose how much they charge their investors annually in percentage terms to compensate for the costs of running investment businesses. A mutual fund's gross return is reduced by the expense ratio percentage, which could be as high as 3%. However, according to fund manager Vanguard, industrywide expense ratios averaged 0.54% in 2020.
Historically, the majority of mutual funds generate market returns if they follow a relatively stable fund such as the S&P 500 benchmark. However, excessive annual fees can make mutual funds an unattractive investment, as investors can generate better returns by simply investing in broad market securities or exchange-traded funds.
Load Charges
Many mutual funds have different classes of shares that come along with front- or back-end loads, which represent charges imposed on investors at the time of buying or selling shares of a fund. Certain back-end loads represent contingent deferred sales charges that can decline over several years. Also, many classes of shares of funds charge 12b-1 fees at the time of sale or purchase. Load fees can range from 2% to 4%, and they can also eat into returns generated by mutual funds, making them unattractive for investors who wish to trade their shares often.
Lack of Control
Because mutual funds do all the picking and investing work, they may be inappropriate for investors who want to have complete control over their portfolios and be able to rebalance their holdings on a regular basis. Because many mutual funds' prospectuses contain caveats that allow them to deviate from their stated investment objectives, mutual funds can be unsuitable for investors who wish to have consistent portfolios. When picking a mutual fund, it's important to research the fund's investment strategy and see which index fund it may be tracking to see if it's safe.
Returns Dilution
Not all mutual funds are bad, but they can be heavily regulated and are not allowed to have concentrated holdings exceeding 25% of their overall portfolio. Because of this, mutual funds may tend to generate diluted returns, as they cannot concentrate their portfolios on one best-performing holding as an individual stock would. That being said, it can obviously be hard to predict which stock will do well, meaning most investors who want to diversify their portfolios are partial to mutual funds.
Advisor Insight
Patrick Strubbe, ChFC, CLU, RFC
Preservation Specialists, LLC, Columbia, SC
Generally speaking, most mutual funds are invested in securities such as stocks and bonds where, no matter how conservative the investment style, there will be some risk of losing your principal. In many instances, this is not a risk you should be taking on, especially if you have been saving up for a specific purchase or life goal. Mutual funds may also not be the best option for more sophisticated investors with solid financial knowledge and a substantial amount of capital to invest. In such cases, the portfolio may benefit from greater diversification, such as alternative investments or more active management. Broadening your horizon beyond mutual funds may yield lower fees, greater control, and/or more comprehensive diversification.
FAQs
Lack of Control. Because mutual funds do all the picking and investing work, they may be inappropriate for investors who want to have complete control over their portfolios and be able to rebalance their holdings on a regular basis.
Are mutual funds a bad investment? ›
In the category of market-linked securities, mutual funds are a relatively safe investment. There are risks involved but those can be ascertained by conducting proper due diligence.
How do I know if my mutual funds are good or bad? ›
Analyzing Mutual Fund Performance
- Analyse Fund Performance vs Benchmark Performance.
- Check the Expense Ratio of Funds.
- Study Fund History.
- Check the Strength of the Portfolio.
- Check Portfolio Turnover Ratio (PTR)
- Compare The Maturity Period of Funds.
- Compare Risk-Adjusted Returns.
Volatility: High-risk mutual funds are more volatile than other types of mutual funds. The value of your investment may fluctuate significantly over time.
What are the risks of mutual funds? ›
All funds carry some level of risk. With mutual funds, you may lose some or all of the money you invest because the securities held by a fund can go down in value. Dividends or interest payments may also change as market conditions change.
What are the main disadvantages of mutual funds? ›
Disadvantages include high fees, tax inefficiency, poor trade execution, and the potential for management abuses.
What is downside in mutual fund? ›
Downside risk is a general term for the risk of a loss in an investment, as opposed to the symmetrical likelihood of a loss or gain. Some investments have an infinite amount of downside risk, while others have limited downside risk.
When should you not invest in mutual funds? ›
Lack of Control. Because mutual funds do all the picking and investing work, they may be inappropriate for investors who want to have complete control over their portfolios and be able to rebalance their holdings on a regular basis.
Should I put all my money in mutual funds? ›
You have to choose mutual funds based on your goals, investment horizon, and risk profile. You should invest in debt schemes to achieve your goals that need to be achieved in five years. You can invest in equity schemes to meet your long-term goals.
What factors to consider while investing in mutual funds? ›
Consider the below factors:
- Identify Your Investment Goals. Know your investment goals, i.e. identify whether you seek growth or value. ...
- Time Horizon. Investment goals and time horizons go hand-in-hand. ...
- Risk Tolerance. ...
- Fund Performance. ...
- Net Asset Value. ...
- AMC Performance. ...
- Expense Ratio. ...
- Exit Load.
A mutual fund's level of risk is determined by the investments it makes. Typically, the risk will increase as the potential returns do. For instance, an equity fund is typically riskier than a fixed income fund because stocks are typically riskier than bonds.
What are the pros and cons of mutual funds? ›
One selling point is that they allow you to hold a variety of assets in a single fund. They also have the potential for higher-than-average returns. However, some mutual funds have steep fees and initial buy-ins. Your financial situation and investment style will determine if they're right for you.
Should I sell mutual funds when market is high? ›
Interrupting or ceasing investments during market peaks or due to apprehensions about a correction is counterproductive to reaching your financial objectives. Bhatt adds, “Instead of stopping completely, you could choose to reduce your SIP or lump-sum amount until market conditions seem less frothy.
Why are mutual funds not risky? ›
All investments carry some degree of risk and can lose value if the overall market declines or, in the case of individual stocks, the company folds. Still, mutual funds are generally considered safer than stocks because they are inherently diversified, which helps mitigate the risk and volatility in your portfolio.
Who can not invest in mutual funds? ›
Except minor (anyone under the age of 18) and NRI but, they can also invest in mutual funds after certain conditions, any amount can be invested in the fund. There are no limits to the amount that can be invested.
What do you think would make a mutual fund a low risk investment? ›
Money Market Mutual Funds
This type of investment offers plenty of liquidity, and because of the types of investments they make, they are considered to be very safe with very little risk of losing money. But unlike savings accounts or CDs, they are not backed by the FDIC.
Why mutual funds are not giving good returns? ›
-If there is a change in the fund manager and the track record of the new fund manager is not promising. -If the Asset Management Company (AMC) is facing uncertainty – either looking at exiting the mutual fund business or too many changes in management.
Can mutual funds go broke? ›
Technically, NO, a mutual fund cannot go bankrupt. It may trade below market value at some point in time if it is an equity fund and there is a market downturn, or in case of rising interest rates for a long term bond fund.. But one cannot lose all their money.. That's because of the way a mutual fund is structured.
Is it better to invest in stocks or mutual funds? ›
Stocks are more appropriate for investors who can monitor their portfolios and the stock market for opportunities. Mutual funds are more suitable for investors who want a fund manager to do all of the work for them. Bernat summarizes what investors should consider before choosing the right approach for their portfolio.
Do mutual funds ever fail? ›
It's common for a mutual fund to outperform its benchmark over a short time horizon – a few years – as happened with Cathie Wood's ARKK. But new research shows that mutual funds fail dismally when performance is measured over the long horizons that retirement-focused investors face.
