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Article Number 3 in the Mutual fund series (For the previous article click here)

In the previous article I had briefly pointed out some of the benefits that mutual funds have to offer. As a brief recap we had seen that mutual funds are beneficial because they are basically managed by professionals, some of them are well diversified and hence less risky, comparatively they cost lower and are convenient. Unlike hedge funds, they are quite transparent and well regulated. There is no shortage in the variety of mutual funds and suit pretty much any investors need. We had also seen that equity oriented funds are quite liquid and provide greater returns but at a greater risk. Finally we had seen the SIP as a wonderful way of investing for those who don’t or can’t invest at one go (lump-sum).

In this article lets see some of the disadvantages of mutual funds.

1) Losses are uninsured, Market risks are real

We had seen in the previous article that mutual funds are well regulated (by the SEC in USA and SEBI in India). However one must remember that they are not insured. Investing in stocks via mutual funds doesn’t provide you with any insurance against losses. If the funds NAV decreases, you lose money for real and there is no compensation or insurance.

However, we must realise its in the very nature of the markets to be uncertain and unpredictable (to an extent). Since we expect higher returns while investing in mutual funds (than say risk free treasury bonds) we must similarly expect a higher risk as well. Risk and reward are usually considered two sides of the same coin.

2) Over diversification? “Diworsification”

Diversification to an extent is good in that it reduces the overall risk of the portfolio but what happens when we do too much of it? It ends up substantially reducing the returns thereby defeating the purpose of investing in mutual funds.

3) Cash

Mutual funds, especially the open ended mutual funds, hold a proportion of their portfolio in cash. This is to ensure the smooth redemption of shares should any investor want to exit the fund. However this could also at times be detrimental because the money which is just sitting in cash isn’t being invested into anything.This might reduces the return of the overall fund.

4) Tax inefficiency

Some of the actively managed funds tend to be tax inefficient. This is due to the constant buying and selling of shares by the fund manager. While this may seem good at first glance, it attracts a good deal of capital gains tax. A solution could be to invest in funds with a low turnover rate. These are usually passively managed or index linked mutual funds. You could also specifically look for funds which are tax efficient.

5) Costs – Hidden and Visible.

Did you ever wonder who pays for all the advertisements you see in the TV about the mutual fund of which you are a proud owner? Its obviously you. You pay for not only the manager who is managing your fund but also the administration (who keeps records, manages your mails, and greets you with a pleasant voice whenever you call them). Most importantly a part of your invested money also goes to fund activities such as advertising the mutual fund on the TV, newspaper, etc and for other marketing/distribution activities. (commonly called the 12B-1 fees).

6) Partial loss of control

 We know by now that mutual funds are managed by professional money managers. Any decision to buy or sell a security is made by the manager and not by you. While this could be advantageous, sometimes it could be disadvantageous as well because you somewhat lose control of your portfolio. For example, the mutual fund manager may buy shares in a company which you are not comfortable with or sell shares of a company which you are quite confident about. You have no option but to bear with it or exit the fund altogether.

7) The elephant and the ant

Mutual funds are similar to elephants and the individual investor to an ant in the stock market. Being an ant has its own advantages at times. An ant can easily get in or out of places unlike an elephant.

Imagine due to some news break or lawsuit or for any other reason a company stock is declining, in such a case its much more easy for an individual investor to exit than a mutual fund. If you had the stock most likely you would be owning a small number of shares in it (say 100 or multiples of it) unlike a mutual fund (who may be owning tens of thousands or even hundreds of thousands of shares).

It also gets increasingly difficult to manage a fund as its size increases as it becomes difficult to allocate such huge amounts of capital.

8) Do mutual funds actually beat the market?

Its interesting to note that more than half of all mutual funds perform worst than the index. [1] (like the DJIA, S&P 500 in the USA and Nifty/Sensex in India) So why not invest in an index linked ETF or a passive index linked mutual fund?

The answer is simple. If you are good at picking the right mutual fund go ahead but for others its probably best to invest in index linked ETF’s or a passive mutual fund (with a low turnover rate).

These are some of the main disadvantages of mutual funds. In the next article we will see the types of mutual funds.

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Image credit – striatic