I’m a Financial Advisor: Why You Shouldn’t Rely Too Much on Mutual Funds
Written by
Angela Mae
Edited by
Gary Dudak
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Mutual funds can be a great investment. On the one hand, they already contain multiple assets within them, meaning you’re diversifying your portfolio simply by having them. This helps mitigate the risks involved with investing.
But that doesn’t mean you should overly rely on them. Like any investment vehicle, they have their downsides, including tax liabilities and fees.
GOBankingRates spoke with Ed Mahaffy — president and senior portfolio manager at ClientFirst Wealth Management — and Michael Collins — CFA, founder and CEO of WinCap Financial — about why you should and should not rely on mutual funds. Here’s what they said.
You Can Diversify in Other Ways
Mutual funds may help balance your portfolio, but they’re not the only option, nor are they necessarily always the best.
“Many mutual funds are simply closet indexers, slightly over-weighting or under-weighting here and there,” said Mahaffy. “You can obtain very similar exposure to a diversified equity portfolio through exchange-traded funds (ETFs) featuring much lower operating expenses, such as SPY, MDY, IWM, VEA.”
You Don’t Have as Much Control Over Your Investments
If you’re looking for a more passive investment option, mutual funds could be a good option. But if you want to have a little more control over how your money’s invested, you might want to diversify with other investment vehicles as well — not just mutual funds.
“Mutual funds pool together the money of various investors and are managed by professional fund managers, which means that investors have limited control over the selection of specific assets in the fund, as it is determined by the fund manager,” said Collins. “This lack of control can be a disadvantage for those who prefer to have more say in their investments.”
They’re Not Always the Most Tax-Efficient
Part of choosing the right investment vehicle means picking one — or ones — that reduce your tax liability and maximize your returns. Mutual funds can be a tax-efficient way to invest, but over-relying on anything could have a negative effect on your overall portfolio if you’re not careful.
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“Open-end ’40 ACT mutual funds typically experience much higher turnover than their ETF counterparts, which can create unnecessary tax liability associated with annual capital gain distributions — gains that you may not have even experienced, depending upon when you purchased the fund,” said Mahaffy.
Fees Can Add Up
While a relatively low-cost way to invest, mutual funds do still come with their share of fees. If you overly rely on them, you could end up paying more than you planned for.
“Fees are the number one reason why mutual funds are at a disadvantage compared to other investment vehicles,” said Collins. “Mutual funds charge fees for managing the portfolio, which can often eat into the returns earned by investors, especially for actively managed funds where the fees can be higher.”
They Trade Less Often Than ETFs
Like exchange-traded funds, or ETFs, mutual funds are pooled investments that let you diversify your portfolio at a relatively low cost. That said, mutual funds trade less frequently than ETFs, something that’s worth noting if you plan to take a more active role in investing. They’re also subject to shareholder demands, which could be more changeable depending on the market.
“Mutual funds only trade once a day versus ETFs, which trade throughout the day,” said Mahaffy. “Also, portfolio managers must meet shareholder distribution demands, which means they may be forced to liquidate shares even though they see value in the market. Conversely, they need to make purchases with inflows — money that may be chasing recent performance.”
Of course, trading less often isn’t necessarily a bad thing. It depends on how the funds are managed and, of course, the returns.
There’s Always the Risk of Underperformance
On a similar note, mutual funds still carry the risk of underperforming, something that could have serious repercussions for your investment if you’ve invested solely in them.
“Despite being managed by professionals, mutual funds are not immune to market volatility and changes in economic conditions,” said Collins. “So, there is always a risk that a mutual fund’s performance may not meet your expectations or perform worse than expected, resulting in lower returns or even losses.”
Who Should Invest in Mutual Funds?
It’s important to choose the right types of investments for your risk tolerance, goals, and experience. On that note, mutual funds could be a good option for newer investors or those with moderate risk tolerance.
“Mutual funds are best suited for long-term investors with a moderate risk tolerance who do not want to spend too much time managing their investments and are comfortable with giving up some control over their portfolio,” said Collins. “However, ETFs can often offer similar results at a lower fee.”
Should You Avoid Mutual Funds?
Not relying solely on mutual funds is one thing, but should you avoid them altogether?
“I would not advise against mutual funds altogether as they can offer certain advantages such as access to professional management and diversification benefits,” said Collins.
“Certain actively managed mutual funds have consistently outperformed the market on a risk-adjusted basis as they successfully use their ability to select securities outside the confines of the published indices or corresponding ETF roster,” added Mahaffy. “Moreover, sometimes it may be worth the higher expenses if the fund is consistently delivering alpha.”
Diversifying Further With Other Investment Vehicles
Rather than overly rely on mutual funds, you can always invest in other things — depending on your own goals and risk tolerance. This could include stocks or bonds, index funds, or ETFs. Just do your due diligence beforehand.
“As always, it depends upon the individual situation, but generally, be sure that you know what you own — what holdings your mutual fund has and whether there exists overlap with other funds you may own,” said Mahaffy. “Attempting to diversify without first understanding what you already own is futile. Only then can you implement an asset allocation that properly reflects your goals and risk tolerance.”
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