5 Limitations of a Mutual Fund

Mutual funds are one of the most popular ways to invest, especially for beginners. They offer diversification, professional management, and easy access, all of which attract new and active investors.

Mutual funds, like all other investment products, are not perfect. Many people are only concerned with the benefits, ignoring the drawbacks that may affect long-term returns, flexibility, or costs.

In this blog, we will go over five limitations of mutual funds that all investors should be aware of before investing.

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What Is a Mutual Fund?

A mutual fund brings together money from many investors and invests it across assets like stocks, bonds, or both. Professional managers make decisions about investments that help the fund reach its goals.

How Do Mutual Funds Operate?

Investing in a mutual fund involves purchasing units of the fund.

• These units show how much of the fund's total assets belong to you.
• The value of each unit is known as NAV (Net Asset Value), and it varies daily depending on market performance.
• Each investor gets a share of the profits and losses based on how much they put in.

Top 5 Limitations of Mutual Funds

Mutual funds are one of the most popular investment options in India, particularly for new and long-term investors. They provide diversification, professional fund management, and low entry barriers with SIPs. However, they are not risk-free or suitable for all investment objectives.

Before investing, it's critical to understand not only the benefits but also the drawbacks of mutual funds so you can make informed decisions based on your financial needs, risk tolerance, and investment horizon.

Here are five limitations of mutual funds every investor should consider.

1. Limited Control Over Your Money

When you invest in a mutual fund, you give the fund manager authority to make decisions. This means that, even if you have a different market outlook, you cannot select specific stocks or sectors for yourself.

Why it matters:

Your money could end up in businesses or industries you dislike. A fund may invest more money in real estate or oil and gas, even if you don't want to, due to personal or market preferences.

Example:

If you invest in an equity fund and the fund manager increases exposure to cyclical stocks just before a downturn, you are stuck with the decision. You cannot change the allocation unless you exit the fund completely.

Before making an investment, review the fund's investment strategy and sector exposure. If you prefer control, look into direct stock investing or ETFs.

2. Expense Ratios Can Eat Into Your Returns

Mutual funds charge an annual fee called the expense ratio, which covers fund management, marketing, distribution, and admin costs. This fee is deducted from your investment every year—even if the fund underperforms.

Why it matters:

Your net return goes down when your expense ratio goes up. A difference of 1% to 2% in your long-term investments can have a big effect on your overall wealth.

• Assume two funds earn a 12% gross annual return.
• Fund A has a 1% expense ratio and a net return of 11%.
• Fund B's expense ratio is 2.25%, yielding a net return of 9.75%.
• An investment of ₹5 lakh can result in a significant difference over 15 years.

Tip: Always compare expense ratios, especially for funds in the same category. Index funds and ETFs typically have much lower fees.

3. You’re Still Exposed to Market Risks

Many people believe mutual funds are “safer” because they are diversified. While that’s partly true, they are still exposed to systemic market mutual fund risks—especially equity funds.

Why it matters: Even the best-managed fund will lose value during a broad market correction. Diversification reduces risk but doesn’t eliminate it.

In March 2020, when COVID-19 hit the market, most equity mutual funds lost 25% to 35% of their value. This included funds with high-quality stocks.

Tip: Select a fund that matches your risk tolerance. If you want to reduce volatility, consider investing in balanced or debt funds; however, they do carry some risk.

4. Returns Are Not Guaranteed

Mutual fund returns can be very different from one fund to another, unlike government programs or fixed deposits. They depend on the economy, the sector chosen, the knowledge of the fund manager, and the performance of the market.

Why it matters:

Many investors enter mutual funds expecting 12–15% returns consistently. In reality, performance fluctuates—sometimes for years.

Example:

A mid-cap fund may return 20% one year and -5% the next. A debt fund may produce steady returns for years before suffering a credit default (as happened with IL&FS in 2018).

Tip: Recognise that mutual funds are market-linked products. Do not rely solely on past performance or online rankings. Consider long-term consistency and fund fundamentals.

5. Exit Loads and Tax Rules Can Reduce Net Gains

If you redeem your investment within a specific period of time—typically within a year for equity funds—some mutual funds impose a penalty known as an exit load. Additionally, gains are liable to capital gains tax.

Why it matters:

Mutual fund drawbacks include the potential to lose a portion of the returns if money is withdrawn too soon. Many investors overlook taxes when calculating their overall profit.

Example:

If you redeem equity mutual fund units within one year, you may incur a 1% exit load.
The short-term capital gains (STCG) tax of 15% on your profits.
Over time, these fees can reduce your net returns.

Tip: Plan your holding period meticulously. Holding equity funds for more than a year reduces taxes (LTCG of 10% over ₹1 lakh) and helps avoid exit loads.

Conclusion

Mutual funds are a popular way to invest, particularly for those just starting out. However, as with all financial products, there are some limitations of mutual funds to be aware of. An investment can fail for a variety of reasons, including market risks, fluctuating returns, and tax or exit fees. Though you should be aware of the risks associated with mutual funds, this does not mean you should avoid using them altogether. It simply means making smarter, more informed decisions.