What Are Mutual Funds? Pros, Cons, and Types

Pros and Cons of Mutual Funds

mutual funds at the NYSE
With mutual funds, you can buy a group of stocks or bonds at once. Photo: Pascal Preti

A mutual fund is ​a collection of stocks, bonds, or other investment assets. You own the share of the mutual fund, not the share of the stock itself. The price of each mutual fund share is called its NAV, or net asset value. That's the total value of all the securities it owns divided by the number of the mutual fund's shares. Mutual fund shares are traded constantly. but their prices only adjust at the end of the business day.

 

Advantages

They tend to be less risky than buying individual securities because they are a diversified investment. That means you aren't as dependent on an individual stock and its underlying company. If one of the companies, you own many more stocks to protect your investment.

Mutual funds automatically give you the benefit of professional stock picking and portfolio management. You don't have to research thousands of companies. The managers are experts in each field. It would be nearly impossible for you to become an expert in all the fields in which you'd like to invest. 

Disadvantages

It takes a great deal of time to research mutual funds. To make it worse, the managers of funds change. When that happens, it could affect the performance of your fund even if the sector is doing well. That's really important, because managers constantly change the stocks they own. Even if you look carefully at the prospectus, it might not reflect current stock ownership.

You really don't know what you are buying specifically, so you are totally relying on the expertise of the manager.

The prospectus will warn that past performance is no guarantee of future returns. But past performance is all you have to go on. There's a good chance that a fund that's outperformed the market in the past underperform in the future.

That's especially true if the manager changes.

The biggest disadvantage is that mutual funds charge annual management fees. That guarantees they will cost more than the underlying stocks. These fees are often hidden in several places in the prospectus. 

Types of Mutual Funds

If you can think of an investment type, there is a fund to cover it. For example, although most funds consist of stocks or bonds, you can find a commodities fund that buys the stocks of companies that profit when oil prices rise.

Stock funds focus on types of companies. Here are some popular categories.

  • Small, mid or large cap companies.
  • Value vs growth
  • Domestic, international, emerging market or frontier markets
  • Industries
  • Blue chip vs high tech
  • Dividend producers vs companies that reinvest all profits.

Fixed-income funds also specialize. Money market funds focus on CDs and short-term Treasury bills. Bond funds focus on types of bonds, such as high-yield, blue-chip or government bonds. A third differentiation is short-term, medium-term and long-term bonds.

Actively-Managed Funds vs Exchange-Traded Funds: Actively-managed funds have a manager who decides which security to buy and sell. They normally have a goal that guides the manager's investment decision.

 The manager seeks to outperform their index by trading securities. As a result, their fees are higher. They must, therefore, outperform bot the index and their higher fees. 

Exchange-traded funds simply match an index. Since they don't require much trading, their costs are lower. As a result, these funds have become more popular since the 2008 financial crisis.

Mutual Fund Companies

Mutual funds are managed by hundreds of companies, who have hundreds of funds each. Therefore, most companies focus on specific strategies. Here's the Top 10 mutual fund companies by size, and their strategy:

  1. Vanguard - Low management fees.
  2. Fidelity - Full financial services.
  3. American - Conservative investment strategies that long-term investment timeframe.
  4. Barclays - Target professional, not individual, investors.
  5. Franklin Templeton - Bonds, emerging markets and value companies.
  1. PIMCO - Bond funds.
  2. T. Rowe Price - No load funds.
  3. State Street - Target professional, not individual, investors.
  4. Oppenheimer - Actively managed funds.
  5. Dodge & Cox - Long-term investment timeframe. (Source: Gajizmo, Largest Mutual Fund Companies by Assets)

How Mutual Funds Affect the Economy

A good mutual fund reflects how an industry or other sector is doing. Mutual fund values change on a daily basis. That reflects the value of the assets in the fund's portfolio. The economy is much slower moving, so that wide variations in a fund do not necessarily mean that sector is gyrating as much. However, if a mutual fund price declines over time, then it is a good bet that the sector it tracks is also growing more slowly.

For example, a mutual fund that focused on high-tech stocks would have done extremely well up until March of 2000, when the tech bubble burst. As investors realized that the high-tech companies were not returning profits, they started selling the stocks, and so the mutual funds declined. As the mutual fund/stock prices declined, the high-tech companies could not remain capitalized, and many went out of business. In this way, stock mutual funds and the US economy are inter-related.

How Mutual Funds Affect the Bond Market

Mutual funds that own corporate bonds have become more popular since the 2008 financial crisis. Investors that got burned during the 2008 stock market crash prioritize safety. They are attracted to bonds despite record-low interest rates.

In 2014, bond mutual funds owned 17% of the $36.5 trillion U.S. bond market. That's nearly double their 9% ownership in 2008. 

That's created new risks. Many bond funds now own the same bonds. If one manager starts selling that bond, the others will do the same. The resultant crash in the bond's price would require the issuing company to raise interest rates to keep the bond afloat. 

Corporations issued $300 billion in high yield bonds in each of the last three years. That's double the average annual issuance of $147 billion before 2010. When the Fed raises interest rates it could trigger defaults. 

Low oil prices in 2014 are threatened to trigger potential defaults. In September 2015, 15% of these junk bonds were distressed. That meant they could default in the next six to nine months.

Many investors don't know what bonds are in their funds. A rash of junk bond defaults could prompt them to sell even good bond funds. That would trigger a sell-off that could destroy many funds.

Since bond managers own the same funds, there wouldn't be a lot of buyers for those bonds. That low liquidity would force prices down even lower. Bonds would be subject to the same volatility as stocks and commodities. Examples of that scenario occurred during the bond "flash crash" in October 2014. (Source: "The New Bond Market," WSJ , September 21, 2015.)

Mutual Funds FAQ