Though mutual funds offer investors instant diversification, professional management, a great amount of ease and a modest entry point, there are some drawbacks.
Disadvantage #1: Fees
The first is fees. Over time, management and other fees will have a significant impact on the value of your investment. These fees can add up to 7.5% or more in the first year -- that's a significant bite out of your returns in a good year. In a losing year, these fees make the red ink just that much worse.
Let's look at how a fund with a 5.75% sales load and a 2.0% total expense ratio compares to a investment without such fees. We'll assume a 10% annual return on a $25,000 investment:
Remember, these are the exact same rates of return -- the only difference is the fees that you pay. You'll have to decide if, over time, the return is worth the price. In this case, that's nearly $50,000 -- twice the original value of the investment!
Disadvantage #2: Limited Upside
The second disadvantage to mutual funds is limited upside. The bad news about diversity is that it works both ways -- it protects you from big losses, but it also insulates you from big gains. If all your cash is tied up in a fund, even an aggressive one, then maybe 2% of your dollars are going to be invested in this year's big winner. That's not enough to keep up the gains for the overall fund.
Though most funds are scrupulous, some are not. While they are obligated to report holdings, this obligation must be met only quarterly. Some funds may move money into other areas to try to bolster results and then move them back into more appropriate assets later. This practice is known as window-dressing, and not knowing exactly what you own is a significant disadvantage.
Disadvantage #3: Fund Managers Don't Last Forever
Lastly, fund managers, even good ones, don't last forever. They change jobs, retire and even die. You want to make sure you put your money to work at an investment company that has a deep talent bench with a mix of older, more experienced managers and younger apprentices who will be able to carry on the fund's tradition of excellence.