Mutual funds are popular investment vehicles because they are managed by professionals, can provide diversification, and the investment minimum is usually modest. However, as with any investment vehicle, mutual funds can have both benefits and disadvantages.
In this blog, I describe what mutual funds are, outline some pros and cons, and briefly describe how Freedom Advisors uses mutual funds in its offerings. You can decide if mutual funds are right for your clients.
What are Mutual Funds?
A mutual fund is actually a company. It collects and pools money from many investors and invests it in securities to create a portfolio. The investors who provide the money get shares of the fund. Mutual fund investors do not directly own the securities in the fund. Instead, the fund owns those securities. The investors own a portion of the fund.
Pros of Mutual Funds
Mutual funds are professionally managed
Perhaps one of the most cited benefits of mutual funds is that they are created, managed, and monitored by investment professionals. Many people do not have the expertise to pick securities, create portfolios, and make risk-return tradeoff decisions, nor have the time to manage and to monitor their investments on an ongoing basis. If you buy shares of a mutual fund, someone with financial expertise and experience will invest, monitor, and manage the money for you.
Mutual funds can reduce risk by providing diversification
Mutual funds allow for easy diversification, which may help reduce risk. The diversification can be focused or broad. For example, if an investor is interested in mid cap growth stocks, but does not know which stocks to buy to obtain good returns and to reduce risk, then a good option may be a mutual fund that consists of several dozen mid cap growth stocks chosen by a mutual fund manager. If an investor is interested in investing in a broadly diversified portfolio of stocks, but does not know how to diversify broadly, then one solution may be a mutual fund consisting of a wide variety of stocks of different size firms from different industries and regions. Buying a mutual fund is one of the easiest ways to get the risk reduction benefit of a diversified portfolio.
It is easy to invest in a mutual fund
Mutual funds are directly available from mutual fund companies and most retail investment management companies. For many mutual funds, the minimum investment is typically $1,000 or less.(1) With only $1,000, it may not be possible to hire a professional to invest and manage this small amount. However, $1,000 is enough to buy shares in an already existing mutual fund. This can happen because mutual funds benefit from economies of scale. Because so many investors are pooled together, there is enough money to retain the services of a professional money manager.
Cons of Mutual Funds
Mutual funds can suffer from tax inefficiencies
There are two types of tax inefficiencies inherent in mutual funds.
- Tax inefficiency #1: Mutual funds can suffer from an embedded capital gains problem. This problem occurs because the securities in the fund are not owned directly by the investor. Instead, the fund directly owns those securities, and the investor just owns shares of the fund. This means that the cost basis of the fund’s securities is not determined based on when the investor purchased the fund, but when the fund purchased the security. Here is a hypothetical example to illustrate the potential problem: Imagine that an investor buys a mutual fund today, and it contains stock XYZ at $100 per share. A few weeks later, the stock price falls to $80 per share. Therefore, the value of the mutual fund has declined (assuming everything else stays the same). If the fund decides to sell stock XYZ, then it may have to pay a capital gains tax. Why? The fund may have purchased the stock at $50 per share some time ago. Because the investor who bought into the fund when XYZ was $100 is a part owner of the fund, they will have a taxable realized gain of $30, even though the value of XYZ declined since the investor purchased shares of the fund. According to Morningstar, this tax inefficiency can cost an average of 1.10% per year.(2)
- Tax inefficiency #2: Because mutual funds are bundled investments, investors cannot benefit from tax loss harvesting on individual securities in the fund. For example, if stock ABC in a mutual fund suffers a huge loss, an investor is not able to strip off stock ABC from the fund to realize a loss on the stock.
Mutual funds can have many confusing costs
Mutual funds can have confusing costs and fees. For example, there are shareholder fees, which can consist of front-end loads, back-end loads, purchase fees, redemption fees, exchange fees, and account fees. Loads are sales charges, usually paid to the broker and deducted from your investment. If the sales charge is upfront, then it is a front-end load. If the sales charge is deferred, then it is a back-end load. These load charges are different from purchase fees and redemption fees, which are fees paid to the fund, not to the salesperson.
There are also operating expenses (usually expressed as an expense ratio), which can include management fees, 12b-1 distribution fees, and administrative costs. Finally, another reason why mutual fund costs can be confusing is there are several different classes of mutual funds, such as Class A shares, Class B shares, Class C shares, and Class I shares, each with its own unique fee structure.
Mutual funds can suffer from “invisible” costs
As previously mentioned, a mutual fund owns securities for multiple commingled investors. When the mutual fund trades on behalf of its other investors, it can impose an invisible cost onto all fund shareholders.
There are three sources of invisible costs. First, when other investors buy or redeem fund shares, the mutual fund makes trades to satisfy those transactions and pay broker commissions. Because your client is part owner of the fund, they partially bear these commission costs.
Second, as mutual funds make trades on behalf of others, they may be buying securities at ask prices and selling securities at bid prices. Ask prices are higher than bid prices, and this difference represents the dealers’ profit. It is a cost to the fund and thus also to your client as a fund investor.
Third, because mutual funds are often large institutional investors, when they make large trades it can move stock prices. Their selling can cause stock prices to fall and their buying can cause stock prices to rise. This is known as price impact. These price-impacted securities tend to return to their previous prices after their trades, so some price impacts can cause the fund to lose money. An academic study finds that the average invisible cost is 1.44% per year.(3)
Mutual funds can limit your ability to be an impact investor
Mutual fund investors cannot separate the stocks and/or bonds in the fund. Therefore, if the fund contains a specific stock that an investor does not wish to own, she or he cannot request for that stock to be excluded from the fund. For example, if your client wants to invest in a broadly diversified mutual fund, but does not want to own stocks of firms that sell tobacco or alcohol or use fossil fuels, then you cannot request for those specific stocks to be excluded from a fund that already contains those stocks.
Mutual funds lack transparency
Per regulations, mutual funds only need to report their holdings on a quarterly basis.(4) There can even be a lag between a quarter-end and the time the report is published. Some investors may feel uneasy about not always knowing how their savings are invested.
Mutual funds can underperform
It is well documented that many active mutual funds tend to underperform versus their benchmarks.(5) Underperformance is likely due to the mutual fund cons discussed in this article, including the many costs and fees of mutual funds, tax inefficiency of mutual funds, and invisible costs of mutual funds.
Mutual funds available from Freedom Advisors
Mutual funds are available on the Freedom Advisors platform, many of which are fixed income and alternative mutual funds to meet the needs of investors. Despite the potential negatives, the benefit of diversification and access to asset classes that may not be available directly means mutual funds continue to be a solid choice for some investors.
Advisory services are offered through Freedom Investment Management, Inc. ("Freedom"), a registered investment adviser. Freedom does not provide tax or legal advice. The information contained herein is for informational purposes only. This is not an offer to sell securities or provide investment advice. Investment strategies carry varying degrees of risk to include total loss. The representations and opinions herein are the opinions and view of Freedom and are believed to be reliable but are not guaranteed by Freedom nor its affiliates. When applicable, sources used in forming Freedom’s opinion are cited, however, other sources may be available which contradict Freedom’s opinion, process, and methodology. Potential investors are advised to consult with their financial, tax and/or legal advisors prior to investing.
Sources
(2) https://www.morningstar.com/articles/373782/article
(3) https://www.tandfonline.com/doi/10.2469/faj.v69.n1.6
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