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Are Mutual Funds That Bad?

Much of the literature on the Internet bashes mutual fund investing. The crux of the reasoning is that the vast majority of mutual funds under-perform the market, so why should investors put their money in mutual funds instead of low-fee index funds? Most of the time, mutual fund critics are correct. But just because many mutual funds are bad doesn't mean ALL mutual funds are bad.

To understand why mutual funds can be both good/bad investments, let's go over the advantages and disadvantages real quick:

Advantages of Mutual Funds

Instant diversification: If you choose stocks individually, you could get pummeled if you do not diversify. Mutual funds for the most part provide instant diversification. Of course, so does investing in Exchange Traded Funds or ETFs.

Expert investing: When you invest in a mutual fund, you have an expert (or at least someone pretending to be an expert) invest your money for you. If the mutual fund manager is in fact good, he can beat the market and outperform ETFs. If your manager is no better than a monkey, than you are just paying more fees for less performance.

Prevent Yourself From Making Mistakes: Perhaps the biggest advantage of mutual funds is preventing yourself from making an array of mistakes. Many investors who eschew mutual funds end up vastly under-performing the market because they trade too much, tend to buy high and sell low, do not diversify, or make too risky of investments.

Disadvantages of Mutual Funds

Fees: Compared to most ETFs, mutual funds have higher fees. Some mutual funds charge exorbitant fees, up to 2-3% of assets plus a load. However, many mutual funds have a reasonable expense fee of about 1% of assets and no load. A mutual fund with a 1% expense fee has a reasonably good chance of outperforming the market if indeed the mutual fund manager is an expert in the field and is able to beat the market.

Asset Bloat: Often, once a mutual fund becomes popular, its swells up with investors' money. This makes it harder and harder for a mutual fund to beat the market. It is much easier for a fund to invest $500 million than $50 billion. By getting bloated with investors' money, the mutual fund is forced to only invest in large and mega-cap companies. If a $50 billion fund found a $500 million company to be a good buy, it could only devote a very small percentage of its asset base into the company. After all, just 1% of its funds could buy the company outright!