Like many investments, mutual funds offer advantages and disadvantages, which are important for you to consider and understand before you decide to buy. Here we explore some of the drawbacks of mutual funds.

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Fluctuating Returns

Mutual funds are like many other investments without a guaranteed return. There is always the possibility that the value of your mutual fund will depreciate. Unlike fixed-income products, such as bonds and Treasury bills, mutual funds experience price fluctuations along with the stocks that make up the fund. When deciding on a particular fund to buy, you need to research the risks involved — just because a professional manager is looking after the fund, that doesn’t mean the performance will be stellar.

Another important thing to know is that mutual funds are not guaranteed by the U.S. government, so in the case of dissolution, you won’t get anything back. This is especially important for investors in money market funds. Unlike a bank deposit, a mutual fund will not be FDIC insured.

Diversification?

Although diversification is one of the keys to successful investing, many mutual fund investors tend to overdiversify. The idea of diversification is to reduce the risks associated with holding a single security; overdiversification (also known as diworsification) occurs when investors acquire many funds that are highly related and so don’t get the risk reducing benefits of diversification. To read more on this subject, see this article.

At the other extreme, just because you own mutual funds doesn’t mean you are automatically diversified. For example, a fund that invests only in a particular industry or region is still relatively risky.

Cash, Cash and More Cash

As you know already, mutual funds pool money from thousands of investors, so everyday investors are putting money into the fund as well as withdrawing investments. To maintain liquidity and the capacity to accommodate withdrawals, funds typically have to keep a large portion of their portfolio as cash. Having ample cash is great for liquidity, but money sitting around as cash is not working for you and thus is not very advantageous.

Mutual funds provide investors with professional management; however, it comes at a cost. Funds will typically have a range of different fees that reduce the overall payout. In mutual funds the fees are classified into two categories: shareholder fees and annual fund-operating fees.

The shareholder fees, in the forms of loads and redemption fees, are paid directly by shareholders purchasing or selling the funds. The annual fund operating fees are charged as an annual percentage — usually ranging from 1-3%. These fees are assessed to mutual fund investors regardless of the performance of the fund. As you can imagine, in years when the fund doesn’t make money these fees only magnify losses.

Misleading Advertisements

The different categories that qualify for the required 80% of the assets, however, may be vague and wide-ranging. A fund can therefore manipulate prospective investors by using names that are attractive and misleading. Instead of labeling itself a small cap, a fund may be sold under the heading growth fund. Or, the Congo High-Tech Fund could be sold with the title International High-Tech Fund.

Evaluating Funds

Furthermore, advertisements, rankings and ratings issued by fund companies only describe past performance. Always note that mutual fund descriptions/advertisements always include the tagline past results are not indicative of future returns. Be sure not to pick funds only because they have performed well in the past — yesterday’s big winners may be today’s big losers.

Conclusion

When you buy any investment, it’s important to understand both the good and bad points. If the advantages that the investment offers outweigh its disadvantages, it’s quite possible that mutual funds are something to consider. Whether you decide in favor or against mutual funds, the probability of a successful portfolio increases dramatically when you do your homework.