Mutual funds are popular investment vehicles. And why wouldn't they be? 'Experienced' mutual fund managers take on the task of researching companies, finding undervalued equity investments and trying to make you money while you worry about more important things in life.
As such, mutual funds are a convenient choice for investors where investing authority is transferred to a seasoned investing professional.
Though mutual funds have gained in popularity over the last couple of years and the method of investing is appealing, there are a couple of drawbacks investors need to know about so that they can make an informed decision as to whether mutual funds are the right investment choice for them.
Active vs. passive investments
The very purpose of mutual funds is to invest your money actively.
That means, your fund management company employs a lot of well-paid people who research companies, industries, markets etc. in order to come up with investment ideas. Add to that transaction, marketing, advisory, and distribution costs and investors face a large set of costs; all of which will be eating into your returns.
Financial research and management is an expensive endeavor and the one paying the bill will be you.
On the other end of the spectrum is passive investing, which is also called indexing by professionals.
Passive investing basically implies that investors buy an underlying equity index such as the S&P 500 as opposed to specific constituents (that is, stocks) of any such index. The main advantage: Lower management costs and fees for the investor.
Investors often ask whether the fees charged by mutual funds are really worth it. I doubt it. Research has shown that many active fund managers underperform: They achieve lower portfolio returns than their respective benchmark index thereby raising doubts as to whether the related management costs are really justified.
Standard & Poor's, for instance, concluded that most active fund managers underperform their respective indices. A recent study in the U.K. also came to the same conclusion: Investors were actually better off investing in a passive investment vehicle such as an index fund.
Related to the underperformance theme above, costs are a big issue for mutual fund investors. Many funds charge front-end loads, which basically are just fees. If there is a 2% front-end load and you wanted to invest $100 in a mutual fund, only $98 will be invested.
Though the $2 appears to be a small amount, it surely isn't when compounded over many years. In other words: Front-end loads cut into your performance like nothing else.
Narrow investment mandate
Oftentimes the fund's investment mandate requires managers to invest only in a small group of companies such as businesses that are operating in a specific country, are listed on a certain stock exchange and which fit into a predetermined market capitalization category. In other words:
Many mutual funds sort out a lot of attractive investment opportunities from the get-go. Unfortunately, it is often the smaller, less visible companies in the marketplace that are the most attractive from a risk/return perspective.
The Foolish Bottom Line
Mutual funds are pretty much hyped in the investment industry, because they can be marketed as professional investment vehicles. Research results, however, certainly indicate that mutual funds are not necessarily worth it.
Mutual funds may be convenient choices for investors who want to invest in the stock market without putting in the time, but be sure to know that funds will charge you handsomely for the privilege to earning you a mediocre or inferior return.