Over the course of last few posts, I discussed Mutual Funds, the basics, their types and how to choose a mutual fund. As a concluding post to the Mutual Fund Series, it is only fitting that I list out the advantages and disadvantages of mutual funds, so as to provide you with a wholesome learning. So, let’s cut to the chase and start with the advantages.
- Diversification: One of the rules that investors live by is “Don’t Put All Your Eggs in One Basket”. Asset diversification means mixing the investments within a portfolio to manage risk. This way the negative return of one asset can be offset by the positive return of another asset. A well-diversified portfolio consists of a mix of stocks of different capitalizations from different sectors and industries, and bonds with varying maturities from different issuers. However, for the common individual investor, this is expensive. Here’s where mutual funds come to the rescue by providing immediate diversification and asset allocation by investing in a wide variety of securities. The individual investor can benefit from this at a very low price as the minimum initial investment for a mutual fund is very low.
- Reinvestment of Income: Mutual funds allow the investor to reinvest his dividends and interest to purchase additional fund units. This allows him to grow his portfolio without paying regular transaction fees for purchasing the additional units.
- Economies of Scale: Economies of scale simply is the cost advantage that arises with the increased quantity of a product. For example, suppose an egg costs Rs.4.5. Thus, buying 12 (a dozen) eggs individually will cost Rs.54. However, when you buy a dozen egg as a whole, it costs Rs.48, thus, bringing the price per egg down to Rs.4. Mutual funds utilize the advantage of their buying and selling size to reduce transaction costs, thus increasing the profits for the investors. Buying one security at a time is costlier due to high transaction fees, than buying in bulk. Hence, mutual funds allow an investor to make large-scale transactions at a lesser cost.
- Liquidity: Mutual funds allow an investor to sell his units on any business day and receive the redeemed amount within a short period of time, which is normally 3 to 5 days.
- Flexibility and Variety: Mutual funds allow investors to pick from a wide variety of funds, be it balanced or growth or conservative, sectoral, international, and etc.
- Convenience and Transparency: The investor, has the convenience of periodic purchase plans, automatic withdrawal plans, and automatic reinvestment plans, and is provided with detailed reports of the value of his investment in addition to specific investments made by the mutual fund scheme.
- Professional Management: AMCs hire full-time, high-level investment professionals. Having real-time access to crucial market information, the managers are able to execute trades on the largest and most cost-effective scale. Thus, the individual investor saves time by eliminating the need to do research on his own.
With so many advantages, it seems that investing in mutual funds is a great hassle-free way to grow our wealth. But hold on, every investment has its own limitations and mutual fund investment is no exception. Let’s have a look at the few limitations that a mutual fund investment has:
- Diversification: The most important advantage of mutual fund investments can also turn out to be a disadvantage. How? By over-diversification or Diworsification, which occurs when investors invest in a large number of funds that are closely related (i.e. have similar investment strategies and asset allocation), thus losing out on the risk-reducing benefits of diversification.
- Idle Cash: Mutual funds work by pooling money from many investors and investing it into securities. Since mutual funds allow flexibility of withdrawal and redemption, therefore to maintain liquidity, a considerable portion of their portfolio has to be kept as cash. Thus, the money just sits idle and does not contribute towards earning positive returns.
- Costs: Costs associated with mutual funds can eat away a significant amount of returns. As your investment is handled professionally, operating expenses (like management fees) are incurred, which are borne by the investors, regardless of the fund’s performance. Also, there are transaction charges (Loads) involved during redemption and purchase of units. When the fund doesn’t perform well, these costs magnify the losses.
- No Control on Investment: All the investment decisions are solely taken by the fund manager.
- Deceptive ads: Investors can often be misguided by the misleading advertisements. Incorrect labelling, too many technical jargons, selective advertisements (showing the returns of successful funds only), and etc. often lead the average individual investor to invest in poor quality funds. Forbes has a wonderful article regarding Misleading Ads of Mutual Funds.
To conclude, every investment has its pros and cons. It’s up to us to learn about them and take a decision. After all, it’s our money on the line, the gains will be ours and so will be the losses. Hence, it’s essential that we do our research and make an informed investment decision that will give great returns over the term.
Invest time to do your homework before investing money.