Advantages and Disadvantages of Mutual Funds: Introduction
An organization that pools money from several people and invests it in securities like stocks, bonds, and short-term debt is known as a mutual fund. The portfolio of a mutual fund refers to all of its holdings. Mutual fund shares are purchased by investors. Each share reflects a shareholder's ownership interest in the fund and the revenue it produces.
Any strategy for saving money or investment strategy has advantages of its own. Both in the short term as well as the long term. A mutual fund is something you should strongly consider including in your financial portfolio, regardless of your level of experience. Due to their ability to minimize risk, mutual funds are frequently preferred by investors in India. However, you should be aware of the merits of mutual funds as well as any potential drawbacks. This article is meant to understand the features of mutual funds, explain the advantages of mutual funds and inform about the disadvantages of mutual funds.
Advantages of Mutual Funds
Mutual Funds are one of the most sought-after investment schemes in India owing to the following mutual fund advantages:
Liquidity
Public provident funds and ULIPs are investment instruments that lock up your money for predetermined amounts of time. Fortunately, there is no lock-in period for the majority of mutual funds. Depending on your needs, you can withdraw money whenever you like. Except for equity-linked savings schemes (ELSS), which have a lock-in period of three years, you can receive your money back from open-ended plans from the mutual fund itself at rates based on net asset value (NAV). When the stock market is booming, you can sell your open-ended equities mutual fund units and profit. It is considerably easier to purchase and sell a mutual fund plan unless you choose close-ended mutual funds. Close-ended schemes allow you to sell your units on a stock exchange at the market price or take advantage of the direct buyback option that some close-ended and interval plans provide from time to time at NAV-related rates.
Portfolio Diversification
A mutual fund allocates its entire investment among various asset classes and securities. This ensures diversity and spreads out the risk. Whatever you invest, even a little amount of Rs. 500, will have varied allocations because of mutual funds. Since diversifying portfolios is one of the fundamental principles of investing, using a mutual fund can be an easy and effective way to achieve this objective. They make investments in a variety of businesses in a wide range of sectors and industries. Since not all stocks typically experience losses at the same time and in the same proportion, this feature helps in reducing the risks associated. This also ensures that the losses made in a particular sector/ industry can be offset by the profits made in some other sector/ industry.
Professional Management
Investors who lack the time or expertise to conduct the necessary research and asset allocation are better off using mutual funds. A fund manager handles all of that and decides how to use your investment. You can make sure that only a professional manages your hard-earned money by investing in a mutual fund. These managers can effectively manage your finances due to their particular financial knowledge and skill sets. These professionals are aware of how to pick the stocks that will yield the highest returns.
Depending on the investment goals of the fund, the fund manager and the research team choose suitable instruments, such as equities, debt, or a combination of both. The primary benefit of investing in mutual funds is that they are run by knowledgeable and experienced professionals who are supported by a committed investment research team that evaluates company performance and future prospects and chooses appropriate assets. Furthermore, the fund manager selects the duration of holding the shares.
An important consideration when selecting a mutual fund should be the track record and reputation of your fund manager. The fees of the fund manager are included in the expense ratio, which, according to SEBI, cannot be more than 2.25 percent annualized of the daily net assets.
Convenient Management
To develop your portfolio, you can start with one mutual fund and gradually diversify among funds. It is simpler to select from a range of hand-selected funds that meet your investment goals and risk tolerance. By investing in a mutual fund, you can cut down on paperwork and avoid several issues, including faulty deliveries, late payments, and pointless follow-ups with brokers and businesses. With mutual funds, investment is quick, simple, and convenient.
The method of tracking mutual funds is simple. In accordance with the investment objectives, the fund manager will choose when, where, and how to invest in securities with the support of his team. They must, in essence, regularly outperform the benchmark index and provide investors with the highest returns possible.
Cost Benefits from Scale
Given the costs involved, mutual funds are among the finest investment choices. When compared to investing directly in the capital markets, they are more affordable because of the advantages of scale in terms of brokerage, custodial, and other fees.
You must have noticed how prices decrease as volume increases. For instance, you might be able to acquire a 500g container of toothpaste for, say, Rs 200 if a 200g tube costs Rs 100. The same reasoning also applies to mutual fund shares. Processing fees and other commission costs will be lower if you purchase numerous mutual fund units at once as opposed to just one. The expense of operating the mutual fund is split among all unitholders due to the distinctive structure of mutual funds. This lowers the cost of investing through mutual funds.
Low-Cost Investment Scheme
You can spread out your mutual fund investments over a longer period of time by making smaller denominations of investments. By spreading your investment over lows and highs in the stock market, you lower the average cost of investment. Rupee cost averaging is a perk of regular (monthly or quarterly) investments as opposed to lump-sum investments. Mutual funds allow you to start investing with as little as Rs. 500. You can choose between SIP and lump sum investments based on your budget.
Cost-Efficiency
The expense ratio of several mutual funds can be compared, and the lowest expense ratio should be chosen. Your mutual fund's expense ratio represents the management fee. As they invest in a diverse portfolio of carefully chosen securities, mutual funds have the potential to offer a higher return over the medium to long term.
Tax-Savings
Under Section 80C of the Income Tax Act, some mutual fund schemes provide tax advantages. For instance, equity-linked savings schemes (ELSS), are also referred to as tax-saver funds. These funds offer tax advantages in addition to good profits. Under Section 80C of the Income Tax Act of 1961, it is eligible for a tax deduction of up to Rs 1.5 lakh annually. Long-Term Capital Gains (LTCG) have consistently outperformed other tax-saving products in recent years, even though a 10% tax is applied to LTCG beyond Rs 1 lakh.
Transparency
The common perception is that mutual funds are less secure than bank products. This is a myth as statutory government organizations like SEBI and AMFI have complete authority over fund houses. Account statements provide you with regular updates on the value of your investment, and portfolio disclosures, which show the percentage invested in each asset class provide disclosures on the investments made by your plan. The documents relating to the schemes detail each scheme's asset allocation and investment plan. Furthermore, the credentials of the fund company and the asset manager can be easily verified by SEBI. They also have a platform for unbiased dispute resolution that serves investors' interests.
Limitations of Mutual Funds
The below-mentioned pointers discuss the limitations of mutual funds faced by investors while entering schemes.
High Costs Associated
Although costs were a benefit in the previous section, they are also a drawback for mutual funds. There are some mutual funds in India that come at a significant cost. You will be charged exit fees if you leave before the designated time. You are not permitted to withdraw the money before the allotted time. Along with the fund's operating expenses, investors also pay the market analysts' and fund managers' salaries. When selecting a mutual fund, one of the first factors to take into account is total fund administration fees. Better fund performance is not a guarantee of higher management fees.
Diversification of Funds
Although diversifying your investments helps you avoid losses, it can also work against you by preventing you from making big returns. Some industries provide enormous profits, therefore you could lose a lot of money if you don't invest significantly in them. Diversification can dilute your rewards while averaging your loss risks. As a result, it is recommended that you shouldn't buy a lot of mutual funds at once.
Fluctuating Returns
Probably what you have already heard many a time at the end of TV commercials - “Mutual Fund Investments are subject to market risks”. Returns on mutual funds are not guaranteed because they are subject to market fluctuations. Therefore, before making an investment, investors must be aware of the risk profile of the fund.
What is the expense ratio of a mutual fund?
The annual maintenance fee charged by mutual funds to cover their costs is known as the expense ratio. It covers the fund's annual running expenses, such as management fees, allocation costs, advertising expenditures, etc. The value of an expense ratio is based on how big the particular mutual fund is.
What are the different types of Mutual Funds available in the market?
There are four types of mutual funds in India:
- Equity Funds: The investment is made in equity stocks.
- Money Market Funds: These include short-term debts.
- Balanced or Hybrid Funds: These include both equity stocks and bonds.
- Fixed-Income Funds: This type of fund focuses only on bonds.
What is a Net Asset Value?
The market value of a scheme's assets less its liabilities is its net asset value (NAV). The scheme amount divided by the number of outstanding units on the valuation date yields the per-unit NAV.