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
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.
Are mutual funds a bad investment? ›
Are mutual funds safe? All investments carry some risk, but mutual funds are typically considered a safer investment than purchasing individual stocks. Since they hold many company stocks within one investment, they offer more diversification than owning one or two individual stocks.
How do I know if my mutual funds are good or bad? ›
Check Portfolio Turnover Ratio (PTR)
The portfolio turnover ratio measures the frequency with which a mutual fund buys and sells securities within its portfolio. A high turnover ratio may indicate that the fund manager is actively trading and making frequent changes to the portfolio.
Why are mutual funds considered a high risk form of investment? ›
While mutual funds offer potential benefits, investors also face risks like market fluctuations. Market risk is a primary concern as the value of securities can go up or down based on changes in market conditions. A poorly performing sector or bad fund management could result in substantial losses.
How do you determine if a mutual fund is a good investment? ›
Compare the funds' operating expense ratios—what the fund charges to cover its operating expenses. In addition, be sure to look for any loads—one-time sales commissions—or transaction fees the fund may have.
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? ›
Investors assume a level of risk that a security increases or decreases in value. Downside risk represents the worst-case scenario and may be precipitated by a market or economic event that causes a decline in the security's price in the short term.
When should you not invest in mutual funds? ›
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.
Is mutual fund a good investment or not? ›
Mutual fund investments when used right can lead to good returns, keeping risk at a minimum, especially when compared with individual stocks or bonds. These are especially great for people who are not experts in stock market dynamics as these are run by experienced fund managers.
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.
Equity Mutual Funds are prone to many risks but the most significant one is market risk. Equity Mutual Funds as a category are considered 'High Risk' investment products.
What does a good mutual fund look like? ›
Mutual funds with relatively low expense ratios are generally always desirable, and low expenses do not mean low performance. In fact, it is very often the case that the best-performing funds in a given category are among those that offer expense ratios below the category average.
How do I know if my mutual fund is underperforming? ›
Compare the Fund's Performance to that of its Benchmark
You will know about a fund's benchmark in its factsheet. If the fund has delivered returns above its benchmark, it has performed well. On the other hand, if it has delivered returns below it, it's said to have underperformed.
How do you know if a mutual fund is aggressive? ›
A prospectus of an aggressive growth fund may tell you, for example, that the fund invests in small and often volatile stocks, that it could use products such as derivatives to hedge or to maximize investment returns, and that the fund involves above-average risk.
Why don't people invest in mutual funds? ›
They're prone to market risk
Some of the examples of market risk that mutual funds suffer from are as follows - economic developments, geopolitical scenarios, government policies and legal framework, investor sentiment, interest-rate movements, and unexpected large-scale events.
Can mutual funds go broke? ›
In the case of a Mutual Fund company shutting down, either the trustees of the fund have to approach SEBI for approval to close or SEBI by itself can direct a fund to shut. In such cases, all investors are returned their funds based on the last available net asset value, before winding up.
