Pros and Cons of Mutual Funds

Larry Lane for InvestorZoo.com

Why purchase a mutual fund?
The chief reason investors purchase mutual funds are for diversification. A mutual fund may hold as little as twenty securities all the way to several hundred. These can include stock, bonds as well as cash. If your investable assets are under $50,000, mutual funds can be an ideal tool to diversify your portfolio. By investing in a mutual fund, you are in fact paying for a professional manager or team of managers to oversee your investment. Since mutual fund companies have huge amount of money to invest, they may have the advantage of meeting directly with the CEO and upper management of a company before investing. This is certainly an advantage a mutual fund has over an individual investor. If you are busy living your life or don''t have the investment skills to research individual stocks, purchasing a mutual fund may be the ideal investment.

Need to sell quickly, no problem!
Most investors think of a mutual fund as a long term investment. However, selling a mutual fund is as easy as selling a stock. If you place an order to buy or sell a mutual fund, you will receive pricing at the close of the day; not at the exact time you call to place the order. Mutual funds are considered a very liquid asset.

The pitfalls of mutual funds
As with every security, mutual funds do have their drawbacks. While a mutual fund manager is bound to invest according to the mutual fund''s prospectus, you do not have control over what individual stocks your manager buys or sells. If you have an objection to a certain stock such your manager purchasing a tobacco stock, you have no recourse.

Hot one year, cold the next
With a mutual fund, your money is pooled with other investors. This can create a tremendous problem for you as well as your mutual fund manager. Money may pour into a hot mutual fund you own. This may force the fund manager to hold that money in cash or invest in other stocks outside the fund''s intended purpose. This is generally the reason a top performing fund may suffer in its return the following year. Remember, your mutual fund company is all about their bottom line too. The more money they have in assets under management, they more fees they will bring into their firm.

In addition to inflows, there are redemptions your mutual fund manager must take into account. Should there be a mass exodus of the fund you''ve invested in, your fund manager must sell shares to pay the shareholders who have sold the fund. In many cases, a mutual fund may hold cash to account for redemptions. This may cause problems for you as well as it may put a drag on your total return.

Taxes, taxes, taxes
One huge problem and perhaps the biggest drawback to investing in a mutual fund are the tax liabilities you will have at the end of the year. If you mutual fund manager sold stocks due to shareholder redemption or simply sold stocks because they feel that a particular stock within the mutual fund''s portfolio has reached its full potential return, your fund experiences a capital gain. This capital gain is passed onto you and you must claim it as such on your tax return; even if you haven''t sold any shares. These gains must be distributed to all share holders by the end of the year. Typically a mutual fund will report these gains in November or December. If you are contemplating investing in a mutual fund later on in the year, you must call and ask when their distribution date will occur so you don''t get stuck with a tax bill. Here''s a double whammy: if your fund had capital gains on some stocks but still suffered a loss in NAV (net asset value), you still may be liable to pay the tax for the capital gains generated early in the year.

Note: This only applies to taxable accounts. If you are a mutual fund investor and it is held in a non taxable account such as a 401k or IRA, the above does not apply as you are not taxed until you withdraw your money out of your retirement funds.

Most fund manager do not beat their benchmark
If you are getting a little concerned about mutual fund investing, there''s more sobering news. Most fund managers do not beat their unmanaged benchmarks. Researchers at Standard and Poor''s did a study in 2006 and found that only 38% of large cap fund managers managed to beat the S&P 500 (the standard benchmark which a large cap fund manager would be judged against) over a 3 year period. Over a 5 year period that number drops to 33%. It gets much worse for small cap investors. Small cap mutual fund managers lagged their benchmark by 24% over a 3 year period and just 21% beat the corresponding index over a 5 year term. That means that over a 5 year period, you have a 67 to 79% chance of losing to an unmanaged index. In addition to the reason listed above, there is the human factor. Throughout the history of the market, investors have been seeking the holy grail of investing. If the highest paid smartest mutual fund managers haven''t found it after 100 years, chances are it doesn''t exist.

Fees and commissions
As an investor, you are in effect paying fees to a company to professionally invest your money for you. I can''t think of a single mutual fund that sends you out an itemized bill at the end of the year. However by law, mutual fund companies must send out a prospectus detailing every fee they charge. If you have insomnia, they are highly recommended reading. Before investing, please call the fund company and consult with your financial planner. Get educated about your investment before sending them any of your hard earned money. Remember mutual funds collect their expense fees from you regardless of how successfully they were.

Here''s a highlight of mutual fund fees and expenses:

1)Class A share fund fee-These are typically known as "loaded funds" and will charge a percentage of 1-6%. Over time, this can take a huge chuck out of your total return
2)Class B share fund fee-These are typically know as "back end loaded funds" and will charge a percentage when you sell your shares. Most back end loaded fund charges will dissipate if kept for a number of years. For example, if you keep a back end loaded fund for 5 years, the mutual fund company may waive their fee
3)Investment management fees-This money goes to cover the advertising and salary expenses required to run the fund.
Knowing your fund''s expense ratio is paramount if you are going to have a successful investing career. The average expense ratio for a mutual fund is around 1.5%. This means out of every $10,000 you invest, $150 is being deducted for expenses no matter how your mutual fund performed.
Think expenses aren''t important? Consider this fact: $100,000 invested over 25 years will turn into $684,500 if you achieve an 8% return. If you squeeze out just another 2% more over a 25 year period, you will have nearly $1,100,000; a difference of $415,500. This could be the difference between sipping mojitos on the beach and having to take a job as a greeter at Wal-Mart in your "golden years".

Invest wisely and consult with a financial advisor. Your future may depend on it.

Larry Lane is the editor for InvestorZoo.com, a social network specializing in personal finance. Email questions and comments to Larry.Lane@InvestorZoo.com

The information provided is of a general nature. Always consult with a licensed financial planner before making any financial decision.

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