The Downside of Mutual Funds

I remember the day vividly. It was 2 years ago when I received my first paycheck and despite spending more money in a month than I ever spent in my entire college life, I still had a significant amount of money left in my bank account.

And it was the constant pressure of this very unused and unutilized money lying fruitlessly in my bank account that compelled me to finally ask myself the billion dollar question that every lazy and financially challenged (read: ignorant) person avoids asking himself-

“Where should I invest my savings?”

The choices, like always, were all myriad and unappealing. After all, banks had such low-interest rates, investing in fixed deposits hampered my prized liquidity and PPFs with their 15 years of lock-in period? Don’t even talk about it! What about the stock market? Come on, I was a beginner dude. 

This was until I came across my saviour (Or so I thought) – our very own-Mutual funds! 

No wonder they are so popular.

My money would be managed by professionals with diversified portfolios. I don’t have to care about tracking those complex and cumbersome movements of the stock market.

What else could one ask for? 🙂

But hey, there’s a catch here (like always).

Sorry to break it to you, dear reader. But, the picture isn’t as rosy as you thought it to be. After all, all that glitters is not gold and appearances are more often than not- deceptive.

Don’t believe me?

 “How can the innocent and innately attractive mutual funds have any downsides?” you ask.

Okay, let me tell introduce you to some lesser known facts about mutual funds:

  • Management fees and other expenses-

Well, remember the ads about Mutual Funds you literally know by heart now?

They have large legal and accounting expenses.

They pay salaries.

They mail you your statements every month.

And they have their own profits to make and expenses to cover.

Who do you think pays for them?

Most mutual funds charge fees around 1% to 1.5% annually as a fee for managing the funds, fund managers’ salary, distribution costs etc. In all cases, costs will decrease your overall rate of return. This is one of the most important downsides to using mutual funds and thus, should certainly be evaluated.

  • Excess cash                                                   

Because people occasionally want to withdraw their mutual funds, there must always be funds available – in cash – for payouts. It is great for liquidity, but it also means some of the fund’s money is not earning interest and money sitting around as cash is not working for you and thus is not very advantageous.

  • No guarantee of returns

Although expected returns will be quoted, it is impossible to find a mutual fund with a guaranteed return. This is because all assets carry some degree of risk. However, some mutual funds will carry a higher level of risk than others depending on how well it is diversified.  

  • Too much diversification

Although diversification is one of the keys to successful investing, many mutual fund investors tend to over diversify. Over diversification increases the operating cost of a fund, demands greater due diligence and dilutes the relative advantages of diversification.

  • No Investment Control:

While a mutual fund allows you to select a general type of investment by industry or sector, the fund manager is responsible for choosing the specific investments, and you have no input on this. The fund managers make all of the decisions about which securities to buy and sell and when to do so.

  • Too many variants

To the investor, making a choice among many funds becomes tough when so many variants of the same product are available in the market.  If the funds are similar in objective and performance, investors may find it tough to differentiate the products and make the right choice for their needs.

The bottom line:

There are disadvantages and advantages of investing in each and every investment vehicle. What needs to be considered is whether the advantages outweigh the disadvantages. The probability of a successful portfolio increases dramatically when you do your homework and scrutinize well the downsides and upsides.

Go ahead. Keep learning, saving and investing!

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