Mutual funds are investment vehicles that pool money from many different investors to increase their buying power and diversify their holdings. This allows investors to add a substantial number of securities to their portfolio for a much lower price than purchasing each security individually.
Benefits of Mutual Funds
Risk reduction
As mutual funds are managed professionally it reduces the risk factor. Also, they are invested in a huge number of companies. Thus, the risk factor is reduced more.
Diversification
There are a large number of investors that has savings with them. Thus, these small savings are brought together and a mutual fund is created. So, this can be used to buy the share of many different companies. Also, because of this diversification, the investment ensures capital appreciation and regular return.
Tax advantage
There are many schemes in a mutual fund that provide a tax advantage under the new income tax act. So, the liability of paying the tax of an investor is also reduced. This can be possible only when he/she invests in mutual funds.
Investor protection
Mutual funds are monitored and regulated by the SEBI. Thus, it provides better protection to its investors. Also, this makes sure that there is no legal obligation for the investors.
Disadvantages of Mutual Funds
Although mutual funds can be beneficial in many ways, they are not for everyone.
- No Control over Portfolio. If you invest in a fund, you give up all control of your portfolio to the mutual fund money managers who run it.
- Capital Gains. Anytime you sell stock, you’re taxed on your gains. However, in a mutual fund, you’re taxed when the fund distributes gains it made from selling individual holdings – even if you haven’t sold your shares. If the fund has high turnover, or sells holdings often, capital gains distributions could be an annual event.
- Fees and Expenses. Some mutual funds may assess a sales charge on all purchases, also known as a “load” – this is what it costs to get into the fund. Plus, all mutual funds charge annual expenses, which are conveniently expressed as an annual expense ratio – this is basically the cost of doing business. The expense ratio is expressed as a percentage, and is what you pay annually as a portion of your account value. The average for managed funds is around 1.5%. Alternatively, index funds charge much lower expenses (0.25% on average) because they are not actively managed. Since the expense ratio will eat directly into gains on an annual basis, closely compare expense ratios for different funds you’re considering.
- Over-diversification. Although there are many benefits of diversification, there are pitfalls of being over-diversified. Think of it like a sliding scale: The more securities you hold, the less likely you are to feel their individual returns on your overall portfolio. What this means is that though risk will be reduced, so too will the potential for gains. This may be an understood trade-off with diversification, but too much diversification can negate the reason you want market exposure in the first place.
- Cash Drag. Mutual funds need to maintain assets in cash to satisfy investor redemptions and to maintain liquidity for purchases. However, investors still pay to have funds sitting in cash because annual expenses are assessed on all fund assets, regardless of whether they’re invested or not. According to a study by William O’Reilly, CFA and Michael Preisano, CFA, maintaining this liquidity costs investors 0.83% of their portfolio value on an annual basis.
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