Originally introduced as a way for \’Average Joe\’ to buy into the stock market, Mutual Funds have experienced roaring inflows of investment for decades. Pooling the every day savings of millions of retail investors, they were championed as a great way to get professional investment management.
But more recently mutual funds are losing their attractiveness for many individuals in an increasingly diverse world of financial products. In this article, I\’ll look at what Mutual Funds are, how they work, and some of their associated risks.
Mutual Funds explained
A mutual fund is a corporate structure funded by investors which invests in diversified holdings across a range of assets. Investors give their money to the fund manager, who invests the capital in pursuit of value growth or income. The fund also produces an investment prospectus providing details of what assets will be acquired and how they will be managed.
In theory, this model provides a good source of diversification. Rather than investing in a single company or property, the fund invests your money across a whole range of assets. Funds invest across different geographies, sectors and assets classes, all under the oversight of a professional fund manager.
A mutual fund therefore enables investment in a whole range of assets without needing to worry about exactly which ones to pick.
For example, if an investor wanted to gain diversified exposure to American equities, they could invest in an All American Equity Fund. The fund would invest in common, preferred and convertible stock listed on any US Stock Exchange. The fund might be designed to track the overall market cap, or to target specific sectors, depending on the requirements of the investor.
The danger of Mutual Funds
Essentially, this structure allows you to outsource the management of funds in asset classes which you aren’t au fait with. As with anything though, this comes with a price attached.
Funds charge their investors a fee on assets under management, which is commonly known as an expense ratio. A fund’s expense ratio is basically the advisory or management fee, plus administrative costs, charged on entering (or leaving) a fund. Depending on the fund, this can eat a considerable proportion of the profits, in additional to the risk of miss-selling from salespeople incentivised on a commission.
These costs can seriously dilute returns, as managers and costs are often paid first, leaving investors getting the last cut of profits. These fees are often much higher than in other vehicles such as Exchange Traded Funds (ETFs).
Research also indicates that the vast majority of mutual funds fail to consistently outperform market indices, further reducing the attractiveness of these investment vehicles. After all, why give you money to a Mutual Fund when you could put it in an Index Tracker, pay less, and get a better return?
Why do people continue to invest in Mutual Funds?
Despite these risks, investors continue to put billions of pounds into mutual funds every year. Institutions such as banks and pension advisors continue to sell these vehicles to retail investors. Critics point to the high fees and commission they can charge as evidence of poor suitability.
In my opinion, a general lack of financial literacy impacts understanding of these vehicles, which are hardly sold at gunpoint. As with most things in life, ignorance and misunderstanding lead to dissatisfaction as people continue to invest in these lack-lustre vehicles.
If you’re holding mutual funds, make sure to get an understanding of how they’re performing, both relatively and objectively. Check the expense ratios and associated costs and don\’t be afraid to move your money if you think there’s a more suitable vehicle for your needs.