Although there are many advantages to investing in mutual funds, there are also some disadvantages.

Lower-than-market performance: Generally, most actively managed mutual funds have not beaten their benchmarks over the long-term. While in some years actively managed funds outperform their index fund counterparts, the support for actively managed funds for longer periods of time is low. For the period from 1962 to 1997, the average actively managed fund, or a fund whose purpose is to outperform a specific index by the active buying and selling of securities (which are not index funds), failed to outperform their benchmarks (see Chart 23.1). This chart gives the percentage of actively managed funds that failed to beat their benchmarks after management fees for the past thirty-five years. Interestingly, in twenty-two of thirty-five years, less than half of all actively managed funds beat their benchmarks. One paper that examined mutual fund performance on both a total return and after-tax basis reported:

In general, we find that index funds outperform actively managed funds for most equity and all bond fund categories on both a total return and after-tax total return basis, with the exception of actively managed small company equity and international funds. These results should be viewed with caution, however, as there is evidence that actively managed funds outperform the index funds during periods when the economy is either going into or out of a recession (Rich Fortin and Stuart Michelson, “Indexing Versus Active Mutual Fund Management,” Journal of Financial Planning, vol. 15, no. 9, 2002, p. 82).

 Chart 23.1: Percentage of Actively Managed Funds That Failed to Beat Their Benchmarks

Source: John Bogle, Common Sense on Mutual Funds: New Imperative for the Intelligent Investor, John Wiley & Sons, USA, 1999, p. 119.

High costs: Unless you analyze funds carefully before you buy them, you may inadvertently choose a mutual fund that charges significant management fees, custodial fees, and transfer fees. All of these fees reduce your total amount of return. Moreover, many mutual funds charge loads (sales charges) and 12-b1 fees, which also reduce your total amount of return (Matthew R. Morey, “Should you Carry the Load? A Comprehensive Analysis of Load and No-Load Mutual Fund Out-of-Sample Performance,” Journal of Banking & Finance, vol. 27, no. 7, 2003, pp. 1245-1271).

Risks: Mutual funds are subject to both market-related risks and asset-related risks, particularly in very concentrated portfolios, which are not as well diversified.

Inability to plan for taxes: Mutual funds distribute 95 percent of all capital gains and dividends to shareholders at the end of each year. Even if shareholders do not sell their mutual fund shares, they may be required to pay a significant tax bill each year. Investors may have to pay a significant tax bill on their mutual fund if the fund trades often and has a lot of short-term interest, dividends, or capital gains. It is difficult to plan for taxes because the decisions that affect the amount of taxes you will pay are made by the portfolio manager, not you.

Premiums or discounts: Closed-end mutual funds may be traded at a premium (discount) to the fund’s underlying net asset value. These premiums are based on investor demand more than they are based on actual share value; therefore, premiums are not constant over time.

New investor bias: Shares purchased by new investors dilute the value of the shares owned by current investors. When new money enters the mutual fund at net asset value, the money must be invested, which costs roughly 0.5 percent in an average U.S. stock fund. Thus, the funds of current investors are used to subsidize the purchase of the new investors’ shares.

 

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