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Mutual funds are a popular investment option. Instead of buying individual stocks, buying into a mutual fund can give investors access to a wide range of securities. That can help mitigate risk and diversify your portfolio. Like any investment, mutual funds have potential benefits and drawbacks.
Whether mutual funds are right for you will depend largely on your investment timeline, financial position and goals. Here are some of the pros and cons of investing in mutual funds.
Advantages of Investing in Mutual Funds
Diversification
Mutual funds pool money from multiple investors. By investing in the fund, you're entitled to a slice of any income and capital gains it generates. Another benefit of mutual funds is that they allow you to invest in a variety of securities you might not otherwise explore. That includes:
Mutual funds are diverse by nature, which can help you reduce investment risk. If certain fund assets decrease in value, gains in other areas of the fund—or your portfolio at large—can help offset those losses. In this way, mutual funds are considered less risky than investing in individual stocks.
Potential Returns
Some mutual funds are actively managed. That means they use active trading to try and beat the market, which could result in competitive returns. Others are passively managed and simply track a stock market index to match its returns. Passively managed mutual funds have lower costs and are often recommended for long-term investing.
Holding a diversfied, low-cost passive index fund over the long haul is usually a better strategy than holding individual stocks, according to the Kent A. Clark Center for Global Markets. Average annual returns for the stock market over time, as measured by the S&P 500, have been about 10%.
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Simplicity
Mutual funds offer a relatively easy way to invest. With an actively managed fund, a fund manager will research investment options and make trades on your behalf. Passively managed mutual funds are hands-off investment vehicles that don't require an active role. Both are available through brokerages or fund management companies. The goal of mutual funds is to either match or outperform the market. Just be sure to review the fund's performance and look over its prospectus before investing. It can help you understand its objectives and fees.
Disadvantages of Investing in Mutual Funds
No Guaranteed Returns
Over the five-year period ending in June 2022, very few actively managed funds routinely beat the market, according to the S&P Dow Jones Indices. Index funds may be more stable when it comes to returns, but there are downsides too. Growth can be slower when compared to aggressive, higher-risk investments.
Fees
The minimum investment for a mutual fund can be anywhere from $500 to $3,000, which may be a barrier for some investors. There are also fees to consider.
- Load fees: This is typical for actively managed funds and is charged whenever new shares are purchased. The fee will vary depending on the fund and whether you go through a financial advisor or stockbroker. Load fees might equal 1% to 2% of the sale, or you may pay an annual percentage of your portfolio.
- Operating expense ratio: This covers operational costs and is based on your fund assets. In 2022, the average expense ratio for actively managed mutual funds and exchange-traded funds (ETFs) was 0.59%, according to financial services company Morningstar. That works out to $59 for every $10,000 managed. The average expense ratio for passively managed funds was 0.12%.
- 12b-1 fees: This annual fee may go toward sales and marketing, employee bonuses or shareholder services. The maximum fee is 1% of your fund assets.
Possibly Too Hands-Off
Some investors like being involved in trades and investment decisions. With a mutual fund, a fund manager might handle those details on your behalf. Passive index funds may also feel restrictive for self-directed investors. With a brokerage account, you can buy and sell stocks and other securities on your own. That may be a nice addition (or alternative) to a mutual fund.
Should I Invest in Mutual Funds?
You might consider investing in mutual funds if:
- You have a long investment timeline. Target-date funds, for example, automatically rebalance and become more conservative as you age and get closer to retirement. Index funds are also designed for long-term investing.
- You're looking for a simple way to invest. Both active and passive mutual funds require little involvement. That can make them good set-it-and-forget-it investment vehicles.
- You want diversification. Mutual funds allow you to invest in a variety of asset classes. That can help diversify your portfolio and spread out risk.
That being said, mutual funds aren't for everyone. They may feel limiting to investors who like taking an active role in their holdings. Their fees and potentially high minimum investments can also put off some investors.
Other Investment Options
- ETFs: Like mutual funds, ETFs can hold a variety of assets. That can help you diversify. But ETFs are different in that they're traded like stocks. That means prices fluctuate with supply and demand. Most ETFs are passively managed, and fees tend to be lower when compared with mutual funds.
- Bonds: After you purchase a bond, the issuer that sold it is obligated to repay you with interest. That may be the federal government, a local municipality or a corporation. Bonds typically have lower returns when compared to stocks, but they're seen as low-risk investments.
- Retirement accounts: Individual retirement accounts (IRAs) and 401(k)s are designed specifically for retirement. Common types of these accounts also come with unique tax advantages, which might translate to tax breaks during your working years. Some employers will also match some or all of your 401(k) contributions.
The Bottom Line
Mutual funds have pros and cons like any other investment. One selling point is that they allow you to hold a variety of assets in a single fund. They also have the potential for higher-than-average returns. However, some mutual funds have steep fees and initial buy-ins. Your financial situation and investment style will determine if they're right for you.
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