The Pros and Cons of Investing in Mutual Funds

Akin to baskets of investments, mutual funds pool money from many individual and institutional investors to buy and sell a variety of securities. 

Depending on the stated objective of the fund, it might include stocks, bonds, commodities in different variations.

A mutual fund’s holdings are called its portfolio and each investor owns shares, which are a portion of the portfolio.

When you buy or sell most mutual fund shares, you do it directly with the fund family.

Two of the best-known mutual fund families are Fidelity and Vanguard.

The Pros

When you own shares of a mutual fund, you have a convenient, well-diversified package of many individual investments that would be too unwieldy to manage on your own.

Mutual funds are professionally managed and give you the ability to invest small or large amounts of money, even if you don’t have much financial or investing experience.

Other advantages of mutual funds include ease of dividend reinvestment and safety.  Typically reinvesting capital gains distributions or dividend payments is quite easy with mutual funds.  In addition, because funds are typically well diversified, they are typically safer than individual stocks.

The Cons

The pros sound great, but there are two important cons of investing in mutual funds to keep in mind.

1. They have complicated fees that aren’t always transparent

Mutual funds can be expensive to operate and only some of the costs are covered by the proceeds of the investments. Some also have fees either charged annually or at the time you first purchased shares in the fund.

Others minimize the fees in different ways. However, a relatively newer variation on mutual funds has dramatically lower fees, the exchange-traded fund (ETF), which usually follows the performance of an index, but then you pay a commission when you buy or sell shares in the ETF.

2. Share prices are calculated just once a day

Since a mutual fund is made up of multiple securities, its price depends on the value of all the securities in the fund — due to all the moving parts, this overall value is, known as the net asset value (NAV), is only calculated at the end of each trading day.

This might actually be a blessing in disguise because it prevents you from attempting to day trade mutual funds; unless you’re a professional investor, you don’t have access to the kind of technology that makes anything other than a long-term buy-and-hold strategy feasible.

3. Tax inefficiency

Believe it or not, investors often do not have a lot of choices about when funds make capital gains payments.  This is often because the funds is obligated to buy or sell holdings, make redemptions to cover withdrawals or sell shares to lock in profits – and as a result investors typically receive distributions that are uncontrollable tax events.

4. Slow or poor trading execution

Mutual funds are not well geared for intraday traders.  If you place a buy or sell order anytime before the cut-off time for the same day NAV you’ll get the same closing price as the NAV regardless of when your buy or sell order is execute.

So, investors who want fast same day execution times, maybe because of preferred trading strategies or interest in timing the market mutual funds aren’t quite as good as other assets.

How To Minimize Taxes on Mutual Funds

One way to defer taxes on mutual fund distributions is to own the fund inside of a retirement account, such as a traditional IRA or 401(k). These accounts enjoy tax-deferred growth, which means your profits within them aren’t reported as capital gains.

You don’t get hit with any taxes until you make a distribution from a traditional retirement account after the age of 59½. At that time your profits are taxed as ordinary income, not as capital gains.

Another option is to own mutual funds inside of a Roth IRA. You pay taxes upfront on money you put in a Roth account, but the growth is completely tax-free. That means you could use a Roth account to eliminate taxes on mutual fund distributions.

For more details on the tax treatment of mutual funds, check out the IRS website.

Readers, do you have any experience investing in mutual funds?

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James Hendrickson

James Hendrickson is an internet entrepreneur, blogging junky, hunter and personal finance geek. When he’s not lurking in coffee shops in Portland, Oregon, you’ll find him in the Pacific Northwest’s great outdoors. James has a masters degree in Sociology from the University of Maryland at College Park and a Bachelors degree on Sociology from Earlham College. He loves individual stocks, bonds and precious metals.