There are many excellent reasons to invest in mutual funds.
I believe open-ended mutual funds and exchange traded funds should be the cornerstone of most investors’ portfolios.
This is especially true for young investors. Those starting out, with limited wealth.
So what are the advantages of investing in mutual funds?
As we have seen in previous posts, there are a vast number of mutual funds available for purchase in a multitude of investment styles and asset classes.
This allows you to easily create any combination of assets within your portfolio. Also, to quickly adjust these combinations as your personal circumstances change.
You may even find funds that allow access to investments that you could not acquire on your own. Real estate, venture capital and fine art are examples.
When we discuss asset allocations and portfolio returns, you will see that having ready access to a wide variety of assets is vital to investment success.
Diversification is an extremely important feature of funds, especially for small investors.
Diversification allows one to reduce overall portfolio risk while maintaining the same level of expected returns. It also allows one to invest in riskier assets that have higher expected returns without increasing the overall portfolio risk.
A very useful tool to incorporate in one’s investment strategy.
Due to the number of investments held within a typical mutual fund, there is normally strong diversification. Not always, as we shall discuss later, but normally.
Diversification within a fund will relate to the style of fund. The diversification may be between: companies in specific sectors (e.g. oil and gas sector equity funds); sectors and industries (e.g. domestic equity funds); geographical regions (e.g. country specific, international, or global funds); maturity dates (e.g. long term bond funds); asset classes (e.g. balanced or asset allocation funds).
Smaller investors may not be able to diversify on their own through individual assets. This may be due to the lack of overall wealth, an inability to access investments across all asset classes, or the prohibitive cost in trying to diversify with limited funds.
As one’s wealth grows over time, an individual may be able to achieve adequate portfolio diversification on his own. But for any investor, even larger ones, mutual funds can provide excellent diversification on a cost-effective basis.
Diversification is crucial in investing. But it can be a costly endeavour.
To create a well diversified portfolio requires a significant number of different investments. In diversifying away the non-systematic risk in equities alone may necessitate holding at least 30 different stocks. Then factor in fixed income, money market instruments, and other asset classes (e.g. real estate, commodities) and one’s portfolio can become quite large.
This is especially problematic for investors in two cost-related ways.
First, when trying to diversify within and between asset classes, the average small investor tends to spread themselves thin when acquiring investments.
Second, buying marketable securities (stocks, bonds, etc.) involves paying commissions on each trade. The less securities purchased, or the greater the number of trades made, the higher the relative cost of the acquisition.
For example, if you wish to invest $6,000 in 30 different stocks, you would only be able to invest $200 in each company. That may not allow you to purchase very many shares of any company. In some cases, $200 might not even allow you to acquire 1 share in some popular companies. Companies such as Apple, Google, Intuitive Surgical, Kuoni, Fairfax Financial Holdings, Mastercard, Priceline, Washington Post (and many others) would be excluded from your investment options as all currently trade above $200 per share.
And even with low online brokerage rates of $10 per trade, you will spend $300 on commissions to buy 30 different companies (as opposed to only $10 had you bought just one stock). You will need to generate a portfolio return of 5% just to recover the commission paid. Not an easy endeavour in today’s markets.
By investing through mutual funds, you pool your money with many other investors. This provides an economy of scale to reduce the individual impact of commissions and allows for the purchase of assets of any value. Even Berkshire Hathaway A shares at $102,000 per share.
Economies of scale also allow for better pricing on fixed income instruments. As greater amounts of money market instruments are purchased, the offered interest rate is typically higher than for smaller investments.
Ease of Investing
One thing that brokers and mutual funds are great at is making it very easy to invest.
You can invest in funds either through the specific fund itself or via your brokerage account.
Note that some funds may not be available through your broker. Different brokers may offer different funds. Some offer a better selection than others. When choosing a broker, I suggest you find one that offers a wide selection of funds for purchase.
There are many funds that do not have sales fees (front or back loads) which saves money. Often, brokers waive commissions for the purchase of certain funds that they sell.
Again, when choosing funds or an online broker, consider the transaction costs associated with the fund purchase. Given the number of funds available, you should be able to fulfill your investment objectives entirely with no-load funds.
Many funds allow relatively small initial investments and even smaller subsequent purchases.
Some funds allow for automatic investments via monthly/quarterly/etc. direct debits from your bank account. These Direct Purchase Plans (DPPs) allow investors to invest without making an effort. It is also a superb way to engage in dollar cost averaging. A concept you should utilize and one we will cover later on.
And some funds offer dividend reinvestment programs (DRIPs). Any distributions made from the fund are automatically reinvested into additional shares of the fund. Except for having to pay tax on distributions you do not physically receive, this is an excellent way to invest.
These features are a huge benefit for investors. Especially those just beginning to invest and wish to build up their asset base over time without making conscious investment decisions.
Liquidity, or ease of divesting, is another advantage of mutual funds.
An asset’s liquidity is extremely important when assessing investments. To refresh yourself on why liquidity is important, please review Liquidity Risk for Investors.
With some exceptions, most open-ended mutual funds are valued daily. These funds normally redeem (i.e. buyback) your shares each day based on the fund’s closing net asset value. Because the fund itself redeems the shares, open-ended funds are usually extremely liquid.
And, by posting the net asset value each day, investors have high certainty as to the proceeds they will receive on disposition.
Some believe this to be an advantage. Others a negative.
In theory, having a mutual fund professionally managed should be a positive. The investments made are well researched. The portfolio is monitored to ensure proper construction for the style (e.g. a value equity fund has the best possible value stocks). And when it is appropriate to sell securities, they are sold in a timely manner.
In short, you are letting a professional make the investing decisions for you.
Assuming you are not an investment professional yourself, that should mean better investment decisions will be made than if you were left to your own devices. Also, by delegating asset management to a professional, you do not need to spend your precious time, researching and monitoring multiple investments.
In practice, this advantage does not always arise. In delegating the investment decisions to others, you must pay for that privilege in higher management fees. That might be okay if the annual performance of actively managed funds exceeded passive (no professional decision making) funds. But that is not always the case.
We will look at the active versus passive debate in an upcoming post as it is an important issue.
While these advantages make mutual funds appear the ideal investment, there are some potential drawbacks or issues that must be considered when investing in mutual funds.
We will look at these next time.