Advantages and Disadvantages of Mutual Funds

Advantages and Disadvantages of Mutual Funds

There are a lot of options that people can choose from to safeguard or increase their financial resources. These are called investments. Consumers sometimes buy fixed assets or deposit this money into banks. Options such as FDs safeguard financial resources and also increase them over time. Fixed assets guarantee safeguard unless there’s a mishap, but don’t always increase one’s financial resources.  Mutual funds allow consumers to increase their financial wealth, but only at a risk. They have various advantages and disadvantages of their own.

WHAT IS AN INVESTMENT?

An investment is an asset or item acquired with the goal of generating income or appreciation. Goods that are purchased to be used in the future to create wealth are known as investment. In finance, an investment is a monetary asset purchased with the idea that the asset will provide income in the future or will later be sold at a higher price for a profit.

WHAT ARE TYPES OF INVESTMENT?

There are various types of investment. These include stocks, bonds, index funds, exchange-traded funds, and options. Stocks are shares of a company’s earnings and assets. Companies sell shares of stock in their businesses to raise cash; investors can then buy and sell those shares among themselves. Stocks come with more risk than other investments. A bond is essentially a loan for a company or a government. A bond issuer borrows the bond purchaser’s money and pays them back with interest. They are safer than stocks but offer lower returns. An option is a contract to buy or sell a stock at a set price, by a set date. Options offer flexibility, as the contract doesn’t actually obligate you to buy or sell the stock. Most options contracts are for 100 shares of a stock.

Mutual funds are also a type of investment.

WHAT ARE MUTUAL FUNDS?

Mutual funds are made up of a pool of money collected from many investors. They are invested in securities like stocks, bonds, money market instruments, and other assets. Mutual funds allow investors to purchase a large number of investments in a single transaction. Mutual funds are operated by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors. When a mutual fund earns money — for example, through stock dividends or bond interest — it distributes a proportion of that to investors. When investments in the fund go up in value, the value of the fund increases as well, which means the owner could sell it for a profit. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.

Advantages and Disadvantages of Mutual Funds

WHAT ARE TYPES OF MUTUAL FUNDS?

Money market funds, fixed-income funds, equity funds, balanced funds, index funds, specialty funds, and fund-of-funds are some types of mutual funds.

Money market funds short-term fixed-income securities. These securities can be government bonds, treasury bills, bankers’ acceptances, commercial paper and certificates of deposit. They are safer and offer a lower return than other mutual funds.  Fixed income funds buy investments that pay a fixed rate of return. They aim to have money coming into the fund on a regular basis, mostly through interest. Equity funds are funds that invest in stocks. They aim to grow faster than money market or fixed-income funds, so there is usually a higher risk of loses.

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Balanced funds invest in a mix of equities and fixed-income securities. They balance the risk of loses against aim of achieving higher returns. Most of these funds follow a formula to split the money among the different types of investments. As the name suggests, Index funds track the performance of a specific index. Index funds typically have lower costs than actively managed mutual funds because the portfolio manager doesn’t have to do as much research or make as many investment decisions. Specialty funds focus on specialized mandates such as real estate, commodities or socially responsible investing.

Advantages of Mutual Funds

Diversification

This is one of the prime benefits of mutual funds. Mutual funds invest in various instruments to spread and reduce potential risks. They can hold hundreds or thousands of different securities among different companies, sectors and regions. One of the primary rules of investment is to diversify portfolios, a mutual fund can be a simple and successful way to accomplish this goal. A fund could be investing in the equity market, debt market, money market instruments, etc. If one stock or asset goes down, there will be others that compensate for it. Potential for losses is spread out conservatively. Mutual funds allow accessibility of a diversified pool of securities to single investors who would not have had it otherwise.

Liquidity

Liquidity refers to the ease with which an asset or security can easily bought and sold without causing a major change in the asset or securities’ price. Mutual funds can be bought and sold whenever needed. If there is an urgent need for cash, they can be sold. The investor only has to instruct the broker or financial advisor to do so. Similarly, an investment can be made at any time when excess money is available.

Expert Management

Managing mutual funds is not an easy task. It requires constant investigation, supervision, and management of hundreds of securities. Thus, education, skills and resources are necessary to manage them. Hence, professional asset managers carefully select the securities in which they invest.

Fund houses also manage mutual funds. Each fund house has a fund manager for each mutual fund they provide. Asset/fund managers also employ a group of analysts and experts that produce detailed information set on which the managers rely in order to select securities. These calls are also based on the investment objective of the fund as well as risk tolerance. This is extremely helpful for individual investors who have limited means, access to and knowledge of mutual funds. It is important to notice that professional management is ruled by a wide range of investment, legal and institutional regulations so as to avoid any conflicts of interest.

Advantages and Disadvantages of Mutual Funds

Disadvantages of Mutual Funds

No Assured Return

Profit on mutual funds is solely dependent on the fluctuations in the price of securities. These fluctuations are not under the control of the asset/fund manager or the investor. Returns on mutual funds are based on pure luck. Thus, these funds cannot guarantee a certain return or a certain return on capital. If an investor is very risk-averse and needs absolute guarantee, it would be better to invest in more traditional banking products.

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Definitive Costs

In most of the cases, investors have to pay management, sales and any other operational fees irrespective to the performance of the fund. The fund house has to incur various expenses while maintaining a mutual fund, mainly the salaries of the fund manager and analysts. This money comes from the money the investors have put in, which is charged before the investor is paid. Managers also charge an “operating expense” fees, which is a percentage of what it costs to run the fund.

Dilution

Diversification is a major benefit of investing in mutual funds. It reduces the risk involved by investing in multiple securities. However, it also leads to a dilution of profits. It leads to averaging out of returns on investment. A mutual fund might make a return of 30% on one investment and a negative return on another.

Pros and Cons of Mutual Funds

PROS

CONS
Diversification

No assured return

Liquidity

Definitive costs
Expert management

Dilution

 

 

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Rhythm Bhatia