5 Problems With Mutual Funds 1

5 Problems With Mutual Funds

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First, let me start by saying that there are several advantages of investing with mutual funds, and I do use mutual funds in my portfolios.  However, there are several disadvantages of investing with 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 2

Mutual Fund Disadvantages

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 a transaction fee making it a perfect investment for someone that contributes a small amount regularly — i.e., automatic investment.  On the downside, mutual funds charge an 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 yearly expense is $2,500 — that’s a lot of money!

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

  • A Front-End 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% front-end load, $200 is deducted right away, and only $9,800 is invested.
  • A 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 a 3% back-end load, you’ll walk away with only $9,700.

2. Sub-Optimal Purchases

Mutual funds managers 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 guidelines 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 less desirable stocks.

See my Morningstar Style Box article for an 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, the fund manager can’t focus on the high potential stocks, and the mutual fund becomes a closet index fund — i.e., merely reflecting the average within that particular group.

4. Forced Redemption

Similarly, the fund manager is forced to sell stocks when investors sell shares of the 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 often 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.

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11 years ago

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
11 years ago

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..

11 years ago

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.

11 years ago

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.

11 years ago

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.

Daddy Paul
Daddy Paul
10 years ago

ETF’s are wonderful investments but many are tempted to over trade them.

10 years ago

Your article on mutual fund is very educative. Please I need update on the current situation on mutual fund and update on ETF products for a developing market.

What are the risks associated with ETF?

5 Problems With Mutual Funds

by Pinyo Bhulipongsanon time to read: 3 min
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