What is a Mutual Fund? Pros & Cons

Remember when you were a kid and wanted something expensive? If you couldn’t get your parents to splurge on you, your options were limited. Selling lemonade on the street was the only job you were qualified for, and the change in your piggy bank usually came up short. But if you and your friends all chipped in, together you could put up enough cash to get your desired item. Yes, sharing would be an issue, but combining funds to get previously out-of-reach items isn’t just something kids do.

If you ever pooled money with your friends to buy something when you were young, you’re already familiar with mutual funds. By using mutual funds, investors get access to a wide range of securities, more than they’d be able to afford to buy on their own. But mutual funds have both pros and cons that you should be aware of before purchasing.

If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.

How Do Mutual Funds Work?

Like our childhood example, mutual funds are purchased by various investors looking to get access to a certain sector or niche in the market. Investors pool their money into the fund, which is managed by a professional. The manager buys and sells securities for the fund based on the parameters outlined in the fund’s prospectus.

“Don’t pull all your eggs in one basket” is the sage-like advice behind the mutual fund. If you want a diverse portfolio of stocks but can’t afford to buy positions in 20 different companies, mutual funds provide that exposure. It’s like you’re buying fractional shares in a host of companies through a single security. Mutual funds aren’t traded during open market hours and buying shares in a mutual fund won’t provide any actual claims of ownership on the companies in the fund. Investors can make money in three different ways from mutual funds: dividends, share price appreciation, and capital gains distributions.

Important Mutual Fund Terminology

Review these important terms related to mutual funds:

  • Net Expense Ratio. The net expense ratio tells you how much it’ll cost to own the fund, which is expressed as a percentage like 0.1%. If you invest $10,000 in a fund with a 0.1% expense ratio, you’ll pay the fund company $10 annually.
  • Net Asset Value (NAV). For mutual funds, NAV is simply the total assets of the fund minus its liabilities, which is expressed in the price of the shares. When a fund is said to be trading “below NAV,” it means the price of the shares is lower than the net asset value of the fund would imply.
  • Distribution Yield or SEC-30 Day Yield. Both are used to calculate the dividends mutual funds pay to investors, although consensus is split on which figure is more accurate.
  • Active vs Passive. Active mutual funds have a manager picking stocks and bonds for the portfolio. Passive mutual funds simply follow an index like the S&P 500 in an attempt to match the overall return of that index.

Pros of Investing in Mutual Funds

Here are the advantages of investing in mutual funds:

  • Easy diversification. Thousands of mutual funds exist in the markets focusing on any type of sector, strategy, or region you can think of. Investors can gain exposure to hundreds or even thousands of publicly traded companies through a handful of funds.
  • Access to experienced managers. Mutual funds rose to prominence on the backs of people like Peter Lynch, who successfully ran Fidelity’s Magellan fund for nearly two decades. Professional management used to be out of reach for most investors, but mutual funds give regular folks access to some of the sharpest investing minds. If there’s a mutual fund manager you really believe in, you can put your money where your mouth is.

Pros of Investing in Mutual Funds

Here are the disadvantages of investing in mutual funds:

  • Tax inefficient outside retirement accounts. Mutual funds buy and sell stocks frequently, which means lots of shares are changing hands within the plumbing of the fund. Unlike exchange traded funds (ETFs) which only pay investors through price appreciation and dividends, mutual funds also return profits to investors in the form of capital gains distributions. While no one will turn down a distribution from their mutual fund, this does create a tax liability for investors. That’s why mutual funds are ideally held in tax-advantaged retirement accounts like 401(k)s.
  • Less liquid than ETFs. Unlike ETFs, mutual funds aren’t actively traded on exchanges. Mutual fund shares trade hands at the end of the trading day when NAV is recalculated based on the assets and liabilities of the fund. If you sell an ETF, you’ll have your money immediately. If you sell a mutual fund, you won’t get your money until the next trading day.

Should I Invest in a Mutual Fund?

Mutual funds used to be the backbone of American investing, and for a majority of savers with 401(k) plans, they still are. But mutual funds are also a bit of a dinosaur with inferior liquidity and tax efficiency to ETFs. If you’re investing in a taxable account, ETFs will usually be preferable. But if you’re saving for retirement in a 401(k) or IRA, low-cost mutual funds are still an excellent vehicle.

Work With an Experienced Financial Advisor

If you have any questions about the pros and cons of mutual funds, reach out to a team member from Good Life Financial Advisors of Mount Pleasant today! We’re happy to assist you.

Disclosure

Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF’s net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETGs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.