Understanding Mutual Funds: The Disadvantages

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Understanding Mutual Funds – The DisadvantagesIn last month’s blog posting, we discussed understanding mutual funds, what makes up a mutual fund, and how income can be generated when they are used as a proper investment tool.  We also focused on many of the advantages of investing in mutual funds.  This month, in Part II, we take a look at the disadvantages and risks involved with different types of mutual fund investments.

Disadvantages of Mutual Funds

  1. Unstable returns. Like many other investments, most mutual funds do not offer a guaranteed return and there is always the chance that the individual investments within a fund will decline in value and you will have loss in your principal investment within the fund. Unlike fixed-income investment products, mutual funds typically go up and down daily based on the stocks and other investments within the fund, or “bucket” that make up the fund.
  2. Unsecured. It is important to remember that unlike bank deposits, funds invested in mutual funds are not secured by the United States Government. That means in the case of the dissolution of your investment fund company, you run the risk of losing all or part of your investment with them.
  3. Diversification problems. The fact that mutual funds are diversified is one of the biggest selling points made by advisors encouraging investments in mutual funds. Unfortunately, sometimes companies fill the “bucket” with stocks from the same sectors of securities, so if that particular sector falls, so do all of the investments in the bucket. While a mutual fund may tout diversification, it is important not to rely on your investment advisor or the fund literature on this point. It is best to read and study the prospectuses detail and other information on the fund to see for yourself whether a fund that is recommended for you is truly diversified and doesn’t exceed your risk tolerance.
  4. Idle cash.  Thousands of investors pool their money into mutual funds. Every day, investors are putting cash in and taking cash out. This means that in order to stay liquid and accommodate those transactions, investment fund companies need to maintain a large reserve of cash on hand. This money is just sitting there–it is not working for you.
  5. Costs. While mutual funds are usually professionally managed, that often comes at a price. The more a fund diverts from ordinary indexed investments, like the S&P 500 and other common indexes, the larger the recurring management fees will typically be.  Funds will have various ranges of fees that affect the bottom line, and they can be substantial. Mutual funds have two classifications of fees: Shareholder fees and annual fees charged for operating the fund. As one can imagine, in years where the funds lose money, these mandatory fees only serve to magnify the losses.
  6. Misleading advertisements and prospectuses. Funds can be inappropriately labeled.  This is something I see more and more of in my law practice, and it makes it very difficult to understand your mutual fund. Labels such as “growth,” “conservative” and “low risk” may or may not be entirely accurate, and very likely do not tell the entire story. The SEC mandates that funds have at least 80 percent of assets in the type of investments for which it is labeled. The remaining 20 percent is left solely to the discretion of the fund manager meaning that he or she can invest in whatever they like. If, for example, a fund labeled as “conservative” has 80 percent of its assets in investments that are actually “growth” assets, and the remaining 20 percent in speculative assets, the result would be far higher risk. For an investor who was seeking a conservative investment, this example could result in major unexpected losses of principal.

As you can see, there is a lot involved in understanding mutual funds. It is critical that the individual investor understands both the positives and the negatives associated with mutual fund investments. Your investment advisor should explain these and other risks and benefits specific to you and your situation. If you choose to go ahead and invest in mutual funds, do your homework instead of relying solely on what you are told by an advisor and the fund literature–and never be shy about asking questions.

If you think that you have been the victim of investment fraud contact Daniel Carlson at the Carlson Law Firm today for a free consultation at (619) 544-9300.