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
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? ›
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.
They're prone to asset risk
Asset risk is the risk of facing losses due to the degradation in the quality of the asset or the company issuing the said asset. Since mutual funds also invest in debt instruments such as corporate bonds and debentures, asset risk is very much a part of it.
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 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.
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 my money safe in mutual funds? ›
Are mutual fund investments safe? Market-linked mutual funds are subject to market risk that can be caused by several reasons such as changes in policy, macroeconomic conditions, pandemics, poor investor confidence and so on. Therefore it is a good idea to go through document papers carefully before investing.
How do I check if my portfolio is good or bad? ›
How to Monitor Your Stock Portfolio?
- Keep Yourself Updated About the Latest News About the Company. ...
- Analyze the Quarterly Results of the Company. ...
- Keep Tabs on Any Corporate Announcements. ...
- Be Aware of Any Changes in the Shareholding Pattern. ...
- Check the Credit Rating of The Company. ...
- Assess the Promoter's Pledge of Shares.
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.
Each mutual fund has a goal that defines its risk profile, investing objective, and overall strategy. Mutual funds offer diversified holdings in many different industries or types of securities. Investing in a mutual fund is a good way to avoid some of the complicated decision-making involved in investing in stocks.
What is the riskiest type of investment? ›
The 10 Riskiest Investments
- Options. An option allows a trader to hold a leveraged position in an asset at a lower cost than buying shares of the asset. ...
- Futures. ...
- Oil and Gas Exploratory Drilling. ...
- Limited Partnerships. ...
- Penny Stocks. ...
- Alternative Investments. ...
- High-Yield Bonds. ...
- Leveraged ETFs.
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.
What is the risk profile of a mutual fund? ›
The risk profile of mutual funds
The risk profile of a scheme is the degree of risk attached to the principal invested. For this, you can refer to the risk profile disclosure on the first page of a mutual fund's scheme information document (SID).
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.
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 is downside in mutual fund? ›
Downside risk is an estimation of a security's potential loss in value if market conditions precipitate a decline in that security's price. Depending on the measure used, downside risk explains a worst-case scenario for an investment and indicates how much the investor stands to lose.
Should I invest in mutual funds when the market is down? ›
Mutual funds are long-term investments, and it's important for you to remain calm during a crash. You need to stay invested and take advantage of rupee cost averaging. Markets have rewarded those who have not pulled out of their investments.
Can mutual funds go broke? ›
Mutual fund liquidations, also referred to as "full closures," are never good news. Liquidation involves the sale of all of a fund's assets and the distribution of the proceeds to the fund shareholders. At best, it means shareholders are forced to sell at a time, not of their choosing.
