Mutual Funds: Profitable Investment Or Risky Business?

Investing in mutual funds is a popular way to grow your money. But is it profitable?

Mutual funds are a type of investment vehicle that pools money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. They are managed by professional money managers and offer several benefits to investors, such as diversification, liquidity, and professional management.

There are different types of mutual funds, including stock, bond, money market, and target-date funds, each with its own investment strategy and level of risk. While mutual funds can provide higher returns than traditional investment options, they also come with fees and expenses that can impact overall returns.

So, are mutual funds a profitable investment? The answer depends on various factors, including the type of mutual fund, investment goals, risk tolerance, and market conditions. In this article, we will explore the profitability of investing in mutual funds and provide insights to help you make informed investment decisions.

Mutual funds vs. fixed deposits

Mutual funds and fixed deposits are both popular investment options, but they differ in several ways. Here is a detailed comparison of the two:

Returns

Mutual funds returns are linked to the market they invest in and depend on the performance of the stock market. The type of fund and the tenure of investment will influence the returns. For example, an equity-based mutual fund from a large-cap company can bring about 15%-20% returns over 3-5 or more years. On the other hand, fixed deposits offer fixed and guaranteed returns at a predefined rate over a specific time.

Risk

The risk involved in a mutual fund varies from fund to fund and is mostly influenced by the market. In contrast, fixed deposits carry zero risk as the depositor will receive guaranteed returns at a fixed interest rate.

Charges and Expenses

Mutual funds carry charges and expenses, such as management fees, that are deducted from the fund. Fixed deposits, on the other hand, do not incur any expenses during initiation or over the tenure of the deposit.

Withdrawals

With mutual funds, you can withdraw your investment free of charge after a certain period. However, withdrawing before the stipulated time will incur an exit load charge of around 1%. Fixed deposits, on the other hand, will need to be broken, and a penalty will be paid for premature withdrawals.

Taxation

Mutual funds are subject to short-term and long-term capital gains tax. Short-term capital gains are charged at a flat rate of 15%, while long-term capital gains are charged at 10% of earnings above a certain threshold. Fixed deposits, on the other hand, are subject to a 10% TDS on interest earned above a certain threshold.

Other Benefits

Mutual funds offer the benefit of professional management, diversification of investments, and the potential for high returns. They also have a relatively low minimum investment requirement, making them accessible to many investors. Fixed deposits, on the other hand, offer zero risk as they are government-backed and provide a guaranteed rate of return. They are also a convenient option for senior citizens, with interest income earned on FDs up to a certain amount being tax-exempt.

Mutual funds for retirement

Mutual funds are a popular investment option for retirement, especially for those who don't want to pick and choose individual investments. They are also a good option for those who want to benefit from the stock market's high average annual returns.

Diversification

Mutual funds are a collection of different assets, such as stocks, bonds, and other investments. This means that if one stock or investment performs poorly, it will have less impact on your overall portfolio. This is especially beneficial for those who are retired and need to cover their bills during a market crash.

Professional Management

Mutual fund managers do the work of buying and selling stocks and other securities on your behalf, saving you time and effort. They are guided by disciplined rules and are not subject to the same emotions as individual investors, which can help maintain discipline during turbulent markets.

Access to Different Markets

Mutual funds provide access to different parts of the market, including large or small companies, growth or dividend-paying companies, and businesses in developed or emerging markets. This allows you to invest in a specific segment of the market that interests you.

Tax Advantages

Investing in a 401(k) or IRA account can provide tax advantages. With a traditional 401(k) or IRA, the money you put in is pre-tax, reducing your taxable income for the year. With a Roth IRA, you pay taxes on the money you put in, but you don't owe any further taxes when you withdraw it.

Fees

Mutual funds have expense ratios, which are annual fees charged by the fund for management and other costs. These fees can eat into your returns over time, so it's important to consider them when choosing a fund.

Overconcentration

While mutual funds offer diversification, investing in too many similar funds can lead to overconcentration in certain assets or sectors. It's important to research the specific investments of the mutual fund to ensure proper diversification.

Capital Gains Taxes

Mutual funds may distribute profits to investors, which can impact the capital gains taxes you owe. It's important to consider the tax implications of any investments you make for retirement.

Risk Tolerance

Your risk tolerance will depend on your age and financial situation. If you are already retired, you may have a lower risk tolerance since you don't have much time to wait out market downturns. If you are decades away from retirement, you can afford to take on more risk since you have time to recover from any losses.

Asset Allocation

It's important to regularly evaluate your investment strategy and asset allocation to ensure you have the right mix of stocks and other investments. This may need to be adjusted as you get older.

• American Funds Tax-Aware Conservative Growth and Income Portfolio (TAIFX)
• Schwab Balanced Fund (SWOBX)
• Vanguard Wellington Fund (VWELX)
• Dodge and Cox Income Fund (DODIX)
• PGIM High Yield Fund (PHYZX)
• T. Rowe Price Dividend Growth Fund (PRDGX)
• Schwab International Index Fund (SWISX)
• Vanguard Long-Term Tax-Exempt Fund (VWLTX)
• BBH Limited Duration Fund (BBBMX)

Mutual fund fees

Annual Fund Operating Expenses

These are ongoing fees that cover the cost of paying fund managers, accountants, legal fees, marketing, and other administrative costs. They are typically between 0.25% and 1% of your investment in the fund per year and are unavoidable. However, different types of funds have different overhead costs. Actively managed funds, which aim to beat average stock market returns, tend to have higher costs than passively managed funds such as index funds, which only mirror a benchmark stock index.

The following are some of the fees included in annual fund operating expenses:

• Management fees: Paid to fund managers and investment advisors for managing the fund's investment portfolio.
• 12b-1 fees: Fees capped at 1% that cover the cost of marketing and selling the fund, as well as shareholder services.
• Other expenses: May include custodial, legal, accounting, transfer agent, and other administrative costs.

Shareholder Fees

Shareholder fees are sales commissions and other one-time costs incurred when buying or selling mutual fund shares. These fees are typically outlined in the fund's prospectus, a legal document that each mutual fund is required to file with the SEC.

• Sales loads: Commissions paid when buying or selling mutual fund shares, also known as front-end or back-end loads.
• Redemption fee: Charged when an investor sells their shares within a short period after purchasing them.
• Exchange fee: Charged by some funds when shareholders transfer their shares to another fund offered by the same investment company.
• Account fee: A fee charged for maintaining an account, often applied if the balance falls below a specified minimum investment amount.
• Purchase fee: Charged by some funds when shareholders purchase their shares, distinct from a front-end sales load.

It's important to carefully review and compare the fees associated with different mutual funds, as they can significantly impact your overall investment returns over time.

Mutual fund diversification

Diversification is a key investment strategy for reducing systematic risk in a portfolio while maintaining expected returns. Mutual funds are already naturally diversified, but there are several ways to further diversify your portfolio.

Diversification by Asset Class

The most common asset classes are exchange-traded funds (ETFs), stocks, bonds, and real estate. Stocks represent the most aggressive portion of your portfolio and provide the opportunity for higher growth over the long term. Bonds provide regular interest income and act as a cushion against the unpredictable ups and downs of the stock market.

Diversification by Fund Type

The best way to diversify your portfolio is to invest in four different types of mutual funds: growth and income, growth, aggressive growth, and international.

• Growth and Income: These funds bundle stocks from large and established companies, such as Apple, Home Depot, and Walmart. They’re also called large-cap funds because the companies are valued at $10 billion or more.
• Growth: These funds are made up of stocks from growing companies, or mid-cap companies valued between $2 billion and $10 billion.
• Aggressive Growth: These funds have the highest risk but also the highest possible financial reward. They’re referred to as “small cap” because they’re valued at less than $2 billion and are possibly still in the startup phase.
• International: These funds are made up of stocks from companies around the world and outside your home country.

Diversification by Cap Size and International Funds

As you explore your account, you’ll see a list of your fund options with different names. They all have different names (like Bank X Growth Fund or Group X International Fund). To diversify your portfolio, you need to spread your money evenly across these four kinds of funds. That way, if one type of fund isn’t doing well, the other three can balance it out.

Meet with Your Investment Pro to Rebalance as Needed

The market is a living and breathing thing, so your funds' values will change over time as they respond to how companies' values rise and fall. That’s why you need to keep an ongoing conversation going with your investment pro and meet regularly to rebalance your portfolio.

Mutual fund risks

Investing in mutual funds is not without its risks. While they are generally considered low-risk, there is always the possibility of losing money. Here are some of the main risks associated with mutual funds:

Market Risk

Market risk, also known as systematic risk, is the possibility of losing money due to poor market performance. This risk is inherent in any investment in the stock market and is beyond the control of the investor. Factors such as natural disasters, inflation, recession, political unrest, and fluctuating interest rates can all impact the market and lead to losses for investors. Diversification of one's portfolio may not help in these scenarios, and investors may have to wait for market conditions to improve.

Concentration Risk

Concentration risk refers to investing a significant amount of money in a single scheme or sector. While this strategy can lead to substantial profits, it also increases the potential for losses. To minimise this risk, investors should diversify their portfolios across different sectors and asset classes.

Interest Rate Risk

Interest rate risk arises when interest rates change during the investment period, leading to a reduction in the price of securities. For example, if interest rates increase, the price of bonds typically decreases, resulting in a loss for the investor. Conversely, if interest rates decrease, investors may be unable to sell their bonds at a profit.

Liquidity Risk

Liquidity risk refers to the difficulty of redeeming an investment without incurring a loss. Mutual funds with long lock-in periods, such as ELSS funds, often carry liquidity risk. Additionally, exchange-traded funds (ETFs) may suffer from liquidity risk if there are no buyers in the market when an investor needs to redeem their investment.

Credit Risk

Credit risk is the possibility that the issuer of a mutual fund scheme will be unable to pay the promised interest. This risk is higher for debt funds, as fund managers may include lower credit-rated securities to increase potential returns. Before investing in a debt fund, it is essential to review the credit ratings of the securities in the portfolio.

Inflation Risk

Inflation risk is the risk of losing purchasing power due to a rising inflation rate. If the returns on investments do not keep up with the rate of inflation, investors will see a decrease in the value of their investments.

Management Risk

Management risk is the possibility that the fund's management team will make poor investment decisions, leading to negative returns. It is important for investors to carefully review the fund's prospectus and consider their own risk tolerance before investing.

Tax Inefficiency

Mutual funds may also carry tax risks, as investors typically have no control over capital gains payouts. Distributions from the fund may be considered taxable events, and poor trade execution can further impact an investor's tax liability.

Frequently asked questions