Investing in a mutual fund is like an investment made by a collective group of individuals. An individual as a single investor is likely to have a lesser amount of money at disposal than say, a group of friends put together. Now, let’s assume that this group of individuals is a novice in investing and so the group turns over the pooled funds to an expert to make their money work for them. This is what a professional Asset Management Company does for mutual funds. The AMC invests the investors’ money on their behalf into various assets towards a common investment objective.
A mutual fund is at its core a managed portfolio of stocks and/or bonds. We can think of a mutual fund as a company that brings together a large group of people and invests their money on their behalf in this portfolio. Each investor owns shares of the mutual fund, which represent a portion of its holdings.
Advantage of Mutual fund
1. Professional Management – The primary advantage of funds is not having to pick stocks and manage investments. Instead, a professional investment manager takes care of all of this using careful research and skillful trading. Investors purchase funds because they often do not have the time or the expertise to manage their own portfolios, or they don’t have access to the same kind of information that a professional fund has. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments.
2. Diversification – By owning shares in a mutual fund instead of owning individual stocks or bonds, your risk is spread out across many different holdings. The idea behind diversification is not to put all of your eggs in one basket – instead, spread investments across a large number of diverse assets so that a loss in any particular investment is minimized by gains in others. In other words, the more stocks and bonds you own, the less any one of them can seriously hurt your finances. Large mutual funds typically own hundreds of different stocks in many different industries. It wouldn’t be practical for an investor to build this kind of a portfolio with a small amount of money.
3. Simplicity – Buying a mutual fund is fairly straightforward. Many banks or brokerage firms have their own line of in-house mutual funds, and the minimum investment is often small.
4. Transparency – Mutual funds are subject to industry regulation that ensures accountability and fairness to investors
Disadvantages of Mutual fund
1. Costs and Fees – Creating, distributing, and running a mutual fund is an expensive undertaking. Everything from the portfolio manager’s salary to the investors’ quarterly statements cost money. Those expenses are passed on to the investors. Since fees vary widely from fund to fund, failing to pay attention to the fees can have negative long-term consequences. Actively managed funds incur transaction costs that accumulate over each year. Remember, every dollar spent on fees is a dollar that is not invested to grow over time.
2. Dilution – It’s possible to have poor returns due to too much diversification. Because mutual funds can have small holdings in many different companies, high returns from a few investments often don’t make much difference on the overall return. Dilution is also the result of a successful fund growing too big. When new money pours into funds that have had strong track records, the manager often has trouble finding suitable investments for all the new capital to be put to good use.
3. Liquidity – A mutual fund allows you to request that your shares be converted into cash at any time, however, unlike stock that trades throughout the day, many mutual fund redemptions? take place only at the end of each trading day.
4. Taxes – When a fund manager sells a security, a capital-gains tax is triggered. Investors who are concerned about the impact of taxes need to keep those concerns in mind when investing in mutual funds. Taxes can be mitigated by investing in tax-sensitive funds or by holding non-tax sensitive mutual fund in a tax-deferred account, such as a 401(k) or IRA.
5. Cash Drag – Mutual funds require a significant amount of their portfolios to be held in cash in order to satisfy share redemptions each day. To maintain liquidity and the capacity to accommodate withdrawals, funds typically have to keep a larger portion of their portfolio as cash than a typical investor might. Because cash earns no return, it is often referred to as a “cash drag.”