Mutual funds are also sometimes known as open-end funds. These are portfolios of securities, mainly stocks, bonds and money market instruments. There are several important aspects of mutual funds. First, investors in mutual funds own a pro rata share of the overall portfolio. Second, the investment manager of the mutual fund actively manages the portfolio, that is, buys some securities and sells others. Third, the value or price of each share of the portfolio, called the net asset value (NAV), equals the market value of the portfolio minus the liabilities of the mutual fund divided by the number of shares owned by the mutual fund investors. Fourth, the NAV or price of the fund is determined only once each day, at the close of the day. For example, the NAV for a stock mutual fund is determines from the closing stock prices for the day. Fifth, and very importantly, all new investments into the fund and withdrawals from the fund during a day are priced at the closing NAV (investments after the end of the day or on a non-business day are priced at the next day’s closing NAV).
The number of and assets in mutual funds grew significantly during the 1990s. At this time, there was a significant shift by individual investors from real estate and other tangible assets to financial assets. Discretionary financial assets increased from 34% in 1989 to 44%. Households increased their preference for indirect ownership through mutual funds over direct ownership of stocks and bonds. By the end of 1999, mutual funds accounted for 28% of household discretionary assets, up from 12% at the end of 1989. In addition, 85% of equity-owning households held a portion of their stocks in mutual funds in 1999, up from 50% in 1992. From 1990 to 1999, the number of mutual funds also rose, from approximately 2,900 to 8,000. According to the Investment Company Institute, the assets invested in mutual funds have increased significantly, from $134 billion to $6,846 billion in 1999.
Mutual funds must have a few advantages to which this significant growth can be attributed. They are:
Advantages of Mutual Funds:
Diversification:
This is one of the primary advantages of a mutual fund and is one rule of investing that both large and small investors should follow. An effective risk management technique, investors can mix investments within a portfolio. For example, if an investor buys stocks in the retail sector and then offsets them with stocks in the industrial sector, he has reduced the impact of the performance of any one security on his entire portfolio. A truly diversified portfolio is one which contains stocks with varying capitalizations and from different industries and bonds with different maturities and different issuers.
While this may be a tall order for an individual investor, a mutual fund facilitates this. When an investor purchases mutual funds, he is given the immediate benefit of instant asset diversification and allocation without spending a lot of money on creating an individual portfolio. Hence, the investor has readily diversified with minimum investment. As a stock mutual fund invests in many stocks, if a few securities in the mutual fund lose value or become worthless, the loss maybe offset by other securities that appreciate in value. The opportunities are endless: an investor can engage in even further diversification by investing in multiple funds which invest in different sectors or categories. This helps to reduce the risk associated with a specific industry or category.
Economies of Scale:
Economies of scale is a concept which perhaps can be best understood by an example. It is denoted by the way volume discounts work: a lot of stores have this offer that the more of one product that a customer buys, the cheaper that product becomes. Like the price per doughnut is usually lesser for a dozen doughnuts than for a single one. This concept also holds true for the purchase and sale of securities. If an investor buys only one security at a time, the transaction fees will be comparatively higher.
Mutual funds enjoy this advantage due to their buying and selling size and in this way; they reduce transaction costs for investors. When an investor buys a mutual fund, he can diversify without the various commission charges associated with the transaction. If he would have to buy 10-20 stocks needed for diversification, the commission charges he would have to pay would be huge and also, every time he would want to modify his portfolio, he would have to pay additional transaction fees. Hence, with mutual funds, he is able to make transactions on a much larger and cheaper scale.
Divisibility:
This is another advantage that mutual funds offer. Often, a lot of investors don’t have the exact sums of money to buy lots of securities. At most times, a mere $100 or $200 is not enough to buy a round lot of a stock, especially after paying commissions as well. With mutual funds, investors can purchase securities in smaller denominations, ranging from $100 to $1000 minimums. Investors no longer have to wait until they have enough money to buy high-priced investments. This factor is related to the next advantage on our list.
Liquidity:
Mutual fund shares are highly liquid and orders to buy or sell are placed during market hours. But, it should be remembered that orders can not be executed until the close of business when the NAV of the fund can be determined.
Professional Management:
The professional management that a mutual fund offers is definitely an important advantage. The investment professionals, who manage and supervise the mutual funds, decide when to buy or sell securities according to the stated objectives in the prospectus, prevailing market conditions and other factors. Hence, the investor does not have to deal with the hassle of trying to time the market. Also, the investor does not have to deal with the cost of following the ode of due diligence when researching securities. On the contrary, this and the other costs of managing numerous securities is divided among all the investors in proportion to the amount of shares they own with a fraction of each dollar invested used to cover the expenses of the fund.
Mutual funds are also highly convenient because buying and selling shares, changing distribution options, and obtaining information can be accomplished conveniently by telephone, by mail, or online. They are not without disadvantages though. There are a couple of reasons due to which the growth of mutual funds has been slowing recently.
Disadvantages of Mutual Funds:
Fluctuating Returns:
At the end of the day, mutual funds are like the many other investments without a guaranteed return. The possibility of the depreciation of the value of the fund is always present. These funds are an example of variable income products and unlike the fixed income products (such as bonds, treasury bills), mutual funds experience value and price fluctuations in accordance with the stocks that comprise the fund. A thorough research of the inherent risks is necessary and it should not be thought that the supervision of a professional manager is the guarantee of a high-performing fund.
U.S. Government, so in the case of dissolution, investors do not get anything back. This counts for a lot in the view of investors in money market funds. A bank deposit would be FDIC insured, but a mutual fund does not have any such backing.
Diversification:
This was present in the list of advantages but also makes its appearance here. Diversification might be necessary for successful investing, but a lot of mutual fund investors tend to take it to the extreme. The concept behind diversification is to reduce the risks associated with holding a single security; but when investors over-diversify (or engage in a process also known as diworsification), they acquire many funds that are highly related and in this way, do not enjoy the risk reducing benefits of diversification. Another key point in this regard is that ownership of mutual funds does not mean automatic diversification. For example, a fund that invests only in a particular industry or region is still comparatively risky.
The cash aspect:
The liquidity aspect of mutual funds can also work against it sometimes. Since mutual funds pool money from thousands of investors, there is a lot of cash activity happening everyday as investors put money into the fund and withdraw investments. In order to maintain ample liquidity and the ability to withstand withdrawals from the fund, funds usually keep a large portion of their portfolio as cash. This cash is dormant; it provides liquidity but does not work for investors and hence, can not be very advantageous.
Costs of the mutual fund:
The professional management which mutual funds provide comes at a cost. There are two types of costs borne by investors in mutual funds. The first is the shareholder fee, usually called the sales charge. This cost is a one-time charge debited to the investor for a specific transaction, such as purchase, redemption or exchange. The type of charge is related to the way the fund is sold or distributed. The second cost is the annual fund operating expense, usually called the expense ratio, which covers the fund’s expenses, the largest of which is for investment management. This charge is imposed annually and is assessed to mutual fund investors regardless of the performance of the fund. So, for the years when the fund doesn’t make money, these fees only magnify losses.
Misleading Advertisements and problems in evaluating funds:
The misleading advertisements of some funds tend to show investors down the wrong path. It is common practice to label funds as ‘growth’, ‘small-cap’ or ‘income’ funds, when these labels might be inaccurate. The requirements of the SEC calls for funds to have not less than 80% of assets in the specific type of investment implied in their names. The remaining assets can be according to the fund manager’s discretion. The loophole comes in because the different categories that can be taken for the required 80% of the assets may be vague and very general. Hence, some funds often manipulate prospective investors by using misleading names such as ‘growth fund’ in place of a ‘small cap’.
Evaluating a fund is a difficult enough task in the first place because in mutual funds, there can be no comparison of the P/E ratio, sales growth, EPS, etc. The NAV of a fund does not imply which fund is better than another. Also, advertisements, rankings and ratings by agencies are based on past performance, which are no indicators of future profits or losses. Hence, investors need to be extremely careful when evaluating a mutual fund to invest in.
The growth of mutual funds might be slowing down to the disadvantages given above. For a lot of investors however, the advantages offered more than make up for the cons. At the same time, the entry of a high proportion of potential investors, the advent of Exchange Traded Funds and other mutual fund alternatives have and will affect the growth of mutual funds.
