There are lots of ads being shown with "mutual fund sahi hai" and all benefits they offer. But are there any disadvantages of mutual funds?
AskedThere are certainly some benefits of mutual funds. But one should also be aware of the disadvantages related to them.
-Locked in clause- there are two types of mutual funds, one allows you to go in and out anytime while the other one is locked in for 5-7 years. You should be aware about the type of mutual funds you are investing in.
-No insurance- even though mutual funds are regulated by the government, there is no insurance against losses.
-Cost- Mutual funds provide professional management, however, it comes at a cost. These management fees can quickly eat up your profits over time. There are two types of fees in mutual funds, shareholder fees and annual fund operating fees.
The shareholder fees is directly paid by the shareholder while purchasing and selling the funds. The annual operating fees are charged as an annual percentage usually ranging from 1-3 per cent. These are to be paid by the investors regardless of the performance of the fund.
-Dilution- Although diversification reduces the element of risk, it can also be a disadvantage due to dilution. For instance, if a a single security in the fund doubles in value, the mutual fund itself would not double in value since that particular security forms only a small part of the fund's holdings.
-Loss of control- All the decisions regarding when and which securities are supposed to sold and purchased are made by the fund managers. This can make it difficult for you to manage your own portfolio.
Trading limitations- Although mutual funds are highly liquid, most mutual funds cannot be bought or sold in the middle of the trading day. You can only buy and sell them at the end of the day, after they have calculated the current value of their holdings.
-Inefficiency of cash reserves- Mutual funds usually maintain large cash reserves as protection against a large number of simultaneous withdrawals. Even though this provides liquidity, it means that some amount of the fund's money is invested in cash which lowers the investor's potential return.
Before you make an investment decision, it is imperative that you learn about the advantages as well as the disadvantages that that particular investment tool will expose you to. Only then can a prudent investor arrive at an optimal decision.
It is true that Mutual Funds offer a gamut of advantages and are ideal for novice investors. However, to say that there are no inherent disadvatages of investing in mutual funds would be incorrect. Mutual Funds have the following disadvantages as compared to other investment options available:
(a) High Costs: The expense ratio for some mutual funds may be higher than the others. The expense ratio depends among other factors on how much active management of the fund is required on part of the Mutual Fund Manager. Passively managed funds like Index Funds and Exchange Traded Funds do not require active participation from the manager and thus have lesser fee as compared to actively managed funds.
Although usually mutual fund companies charge fees for managing the funds, fund managers salary, distribution costs etc., some mutual funds do levy a special cost termed as "exit load" in case you want to sell the investment prior to its maturity. This affects the return that the investor earns on the portfolio. However, fund managers argue that such high costs reflect the quality of service that fund managers provide to investors and are commensurate with the expertise they provide in managing the investors' portfolios.
Therefore, an investor must acquaint himself with the various types of fees mentioned in the offer document and only then make an informed decision.
(b) Diversification: Though this is one of the most significant benefits of investing in a mutual fund as it acts as a cushion during times of loss, it also prevents the investor from making major gains. This is because the money invested in a mutual fund is diversified across various instruments. For example, suppose a stock doubles in price, it does not mean that your portfolio also doubled in value as that particular stock comprises only a small part of your total portfolio. Also, profits earned by one particular stock may be utilized to set off losses incurred in another stock, thereby reducing the overall return on the portfolio.
(c) Inefficiency of cash reserves: It is a common practice for mutual funds to maintain some part of the total portfolio in cash to meet the redemption demands of the investors. Though this provides liquidity to investors, idle cash results in lower potential returns to the investor.
(d) Loss of control: The fund manager is entrusted with the responsibility of managing the investors' funds. This makes it difficult for the investor to manage his own portfolio. For example, the tax consequences of a decision by the manager to buy or sell an asset at a certain time might not be optimal for you. Despite this, mutual funds are popular among investors because of the expertise and acumen that accompanies professional fund managers and because investors do not always have the time to manage their portfolio.
Mutual Funds might be one of the best way of investing money and earning superior returns but at the same time mutual fund investments come with some limitations which an investor must consider before investing in these funds.
Costs
All mutual funds charge a substantial amount to their investors in the form of fund expenses annually. Fund expenses depend on whether a fund is actively or passively managed. Actively managed funds usually have higher expense ratios compared to passively managed funds. Fund expenses usually vary from 1% to 2% of the AUM. Apart from the fund expenses investors investing through the SIP route are charged service fee by their brokers every month and it is followed by GST of 18% on that service charge.
Limited Asset Classes
Mutual fund investments in India are limited to large, mid and small cap equity stocks, bonds, short term debt instruments and liquid market instruments. Mutual funds in India do not invest in gold, real estate, currencies and derivatives. This limits their investment portfolio and also limit their returns to some extent. Investors willing to invest in these instruments and take more risk then have to invest in hedge funds which are again limited.
Disadvantages of diversification
Mutually funds are usually diversified across various sectors, indexes, asset classes etc. in order to decrease the risk but at the same time diversification minimizes the chance of earning extraordinary gains from sudden movements in a particular stock or sector. This is one advantage that investors get in direct equity investments where they can increase their weight on a particular sector or stock as per their own analysis.
These are some of the major disadvantages of mutual funds but these do not deny the fact that mutual funds are one of the best ways of investing for investors because they have huge advantages also at the same time and are very well regulated by central organisations like SEBI and AMFI.