Before you invest in mutual funds, you should do your homework. Which funds are the best to use? Will you choose to use mutual funds, closed-end funds, ETFs, and/or individual stocks and bonds?
Let’s take a look at several so-called disadvantages of mutual funds, and how you can avoid them.
- Some of the so-called disadvantages of mutual funds are myths or do not apply to every fund.
- For example, “hidden fees” must be revealed in the mutual fund prospectus; however, not every mutual fund charges these fees.
- Investors who like the flexibility of ETFs may balk at waiting until the close of market for mutual fund order transactions.
- There are strategies to avoid the capital gains distributions, including tax-loss harvesting and selling a mutual fund prior to the distribution.
1. Mutual Funds Have Hidden Fees
If fees were hidden, those hidden fees would certainly be on the list of disadvantages of mutual funds. The hidden fees that are lamented are properly referred to as "12b-1 fees." While these fees are no fun to pay, they are not hidden. The fee is disclosed in the mutual fund prospectus and can be found on the mutual funds’ websites. Many mutual funds do not charge a 12b-1 fee. If you find the 12b-1 fee onerous, invest in a mutual fund that does not charge the fee.
2. Mutual Funds Lack Liquidity
How quickly can you get your money if you sell a mutual fund, compared to ETFs, stocks, and closed-end funds? If you sell a mutual fund, you typically have access to your cash the day after the sale. ETFs, stocks, and closed-end funds require you to wait two days after you sell the investment. The “lack of liquidity” disadvantage of mutual funds is a myth.
3. Mutual Funds Have High Sales Charges
Should a sales charge be included in the list of disadvantages of mutual funds? It’s difficult to justify paying a sales charge when you have a plethora of no-load mutual funds. But then again, it’s difficult to say that a sales charge is a disadvantage of mutual funds when you have thousands of mutual fund options that do not have sales charges. Sales charges are too broad to be included on the list of disadvantages of mutual funds.
4. Mutual Funds Have Poor Trade Execution
If you buy or sell a mutual fund, the transaction will take place at the close of the market, regardless of the time you entered the order to buy or sell the mutual fund. The trading of mutual funds can be a simple, stress-free feature of the investment structure. However, many advocates and purveyors of ETFs will point out that you can trade throughout the day with ETFs. If you decide to invest in ETFs over mutual funds because your order can be filled at 3:50 p.m. EST with ETFs rather than receive prices as of 4:00 p.m. EST with mutual funds.
5. Mutual Funds Have High Capital Gains Distributions
If all mutual funds sell holdings and pass the capital gains on to investors as a taxable event, then we have found a winner for the list of disadvantages of the mutual funds, but not all mutual funds make annual capital gains distributions. Index mutual funds and tax-efficient mutual funds do not make these distributions every year. Yes, if they have the gains, they must distribute the gains to shareholders.
In addition, retirement plans (e.g., IRAs, 401ks) are not impacted by capital gains distributions. There are also strategies to avoid capital gains distributions, including tax-loss harvesting and selling a mutual fund prior to a distribution.
The Bottom Line
There are advantages and disadvantages of mutual funds as there are advantages and disadvantages to each and every investment vehicle. However, if you come across a list of the disadvantages of mutual funds, scrutinize them and determine whether each applies as a disadvantage of mutual funds in general or a disadvantage of a particular example (or to investment vehicles as a whole, regardless of the structure).