5 Problems With Mutual Funds That You Should Know About

First, let me start off by saying that there are several advantages of investing in mutual funds and I do use mutual funds in my portfolios. However, there are several disadvantages of investing in mutual funds that may not be obvious to new investors. In this article, I’ll review some of the problems with mutual funds that I have discovered over the years.

5 Problems With Mutual Funds

1. Expenses

Mutual funds can be your friend and your enemy when it comes to expenses. On the plus side, some mutual funds do not have transaction fee making it a perfect investment vehicle for someone that contribute a small amount on a regular basis — i.e., automatic investment. On the down side, mutual funds charges annual expense ratio on the entire investment. For example, if a fund has an expense ratio of 1% and you have $10,000 in investment, the annual expense is $100. This is not too bad. However, if you have $250,000, the annual expense is $2,500 — that’s a lot of money!

This disadvantage does not include the many pitfalls, such as upfront load and back-end load.

Upfront load is the amount of money some mutual funds charge for buying your shares. For example, if you invest $10,000 in a fund that charges 2% upfront load, $200 is deducted right away and only $9,800 is invested.
Back-end load, or redemption fee, is the amount of money some mutual funds charge for selling your shares. For example, if you are selling $10,000 out of a fund that charges 3% back-end load, you’ll walk away with only $9,700.

2. Sub-Optimal Purchases

Mutual funds manager cannot hoard cash. When investors buy shares of a mutual fund, the fund manager must turn around and buy shares of stocks that fit within certain guideline specified by the prospectus. For example, if it’s a “Small Value Fund”, the manager cannot buy a “Large Growth” stock even if it represents a better buying opportunity. Additionally, if there are not enough good buying opportunities to choose from, the fund manager is forced to buy stocks that are less desirable.

See my Morningstar Style Box article for explanation of large versus small, and growth versus value.

3. Over Diversification

Either by design, or as a consequence of the problem explained above, many mutual funds suffer from over diversification. Basically, the fund has so much cash that it is forced to own hundreds of stocks within its classification. Consequentially, its impossible for the fund manager to focus on the high potential stocks and the mutual fund becomes a closet index fund — i.e., simply reflecting the average within that particular group.

4. Forced Redemption

Similarly, fund manager is forced to sell stocks when investors sell shares of mutual fund and the fund doesn’t have enough cash reserve to meet the demand. Since rushes of redemption usually happen when the market decline sharply — i.e., a correction or a bear market — this is usually the worst time to sell stocks. However, the fund manager has no choice and has to sell underlying stocks even if it’s not the best financial decision to do so.

5. Tax Consequences

Lastly, mutual funds have a strange characteristic when it comes to taxes. You could owe tax even if the value of your investment is going down! When a fund sells a stock for a profit — whether it’s by design or forced — it passes the tax bill on to you in the form of annual capital gains distribution. If your timing is bad, for example, you buy just before the fund makes its capital gains distribution or you buy during the year that the fund manager is taking a lot of profit, you could end up paying a very big tax bill for no good reason.

How To Avoid Mutual Funds Problems and Pitfalls

As I mentioned at the beginning, mutual funds make sense for some investors under certain circumstances. However, there are occasions when you want to choose other alternatives. In my opinion, one of the best alternatives is Exchange-Traded Funds (ETFs). Although you have to pay trade commissions, the expense ratio is much lower than an equivalent mutual fund. And due to how ETFs are created, the remaining four problems are virtually eliminated.

8 Comments

fathersez
October 7, 2008, 5:20

There is another problem if you may call it. A lack of integrity on the part of the fund managers where they buy a busload of not so good stocks from someone who wants to unload. Most probably there is some sort of a cut for these managers.
When the stocks tank, the fund holders are left holding the baby.
We have had cases in Malaysia where funds (especially some State sponsored funds) have become worthless.
Dividend Growth Investor
October 7, 2008, 14:47

My only problem with mutual funds is that I don’t have a say about the weights of different positions ( I prefer equal weighted portfolios).
Since most people own mutual funds in their tax deffered accounts, i doubt that the tax issues are relevant for most of them..
Pinyo
October 7, 2008, 19:54

@Fathersez — Wow. Thank you for sharing that info about Malaysian Funds. I am not sure if this type of thing happens in US funds, but I am sure there’s a lot of “you do this and I’ll do that” at many levels. A more common problem that I have read about is called “window dressing” where the fund manager will trade out of and into certain stocks to make the prospectus looks good.
@DGI — In this case, ETFs will give you more control since the mix is predefined, but still not as much control as building your portfolio of individual stocks — assuming you have enough money to invest, this could be cheaper too.
Regarding most mutual funds are invested in tax deferred accounts, I supposed this is true given the amount of 401k, 529, and other tax-deferred accounts available today.
Adam
October 8, 2008, 21:57

I’m not sure that I would call sub-optimal purchases a disadvantage. If I am paying a mutual fund manager to invest in small cap value stocks, then that is what I want them to invest in. I invest in the fund because it is in the area that I want. They should not deviate away from that, even if something like large cap is more favorable.
Pinyo
October 8, 2008, 22:11

@Adam – Thank you for your comment. Let me rephrase that. Let say in the universe of small cap stocks (which is what you want your fund to focus on), you can roughly divide stocks into 5 buying grades — excellent, good, fair, poor, and bad. Some funds are so large that they can’t just buy excellent stocks, but are forced to also buy good and fair stocks. I think this is a better explanation of what I am trying to convey.
Nicole
October 17, 2008, 21:13

I am new to the mutual fund business, I would just like to know if right now is a good time to buy long term investments because the market is low right now?
Can someone give me a little educated advice on if I should put some money into mutual right now, or if I should wait because the market is unsecure?
Thank you.
Make Friends, Earn Money
November 7, 2008, 7:05

The tax implications of these funds are rarely considered and yet as you rightly point out you could end up paying tax on a dwindling investment. An excellent review Pinyo, thanks for this.
Pinyo
November 9, 2008, 11:04

@Nicole — Sorry I didn’t answer your question sooner. I think “any time” is a good time for long-term investing. Just set up a pace — i.e., invest $500 a month — and keep going. You’ll buy more when the prices are low and less when the prices are high — and it will average out in the end.
Regarding where, you should look at tax-sheltered accounts like Traditional and Roth IRA first. If you are able to max out the contribution, then look at 401k or other retirement plan. Mutual funds work well in these tax-sheltered accounts where the annual distributions will not hurt your performance and it’s cheaper to buy more shares (usually free if you have no-load, no-transaction fee funds).