Advantages and Disadvantages of Mutual Funds

Introduction

Whether it be for the long term or the short term, every investment plan has advantages of its own. Due to the risk management, investors frequently favour mutual funds for their investments. Of course, there are some drawbacks to these investments as well. In this article, we will explain the advantages and disadvantages of mutual funds.

What Are Mutual Funds?

A mutual fund is a financial instrument that is made by pooling money from several investors. The AMCs(Asset Management Companies) invest in securities such as bonds, shares, debts, stocks, and other assets of mutual fund companies. Further, the mutual fund companies allocate the fund in different types of securities. This allows their investors to grow their profits with these investments. 

Also, the capital gain on a Mutual fund policy depends entirely on the performance of securities it already holds and the ones it decides to purchase. Besides, the value of securities is also determined by the current market condition. Further, the gain generated by these investments is distributed to the investors of that mutual fund scheme. Note that this distribution is only done after deducting all the expenses and is calculated on the basis of NAV (Net Asset Value). 

The Advantages of Mutual Funds

1. Liquidity

The biggest advantage of investing in a mutual fund scheme is that you can redeem your units anytime you want. Unlike FDs (Fixed Deposits), mutual funds offer very flexible and convenient withdrawals. However, factors like exit load and pre-existing penalties should be taken into consideration while exiting from an MF scheme. 

2. Diversification

Diversification is another advantage of mutual funds. It lowers the risks involved in building an investment portfolio and hence reduces the risk for the investors. Because mutual funds contain multiple securities, investors' gains are safeguarded even if there is a drop in some of the securities in their portfolios. 

3. Expert Management 

Beginner investors may not have the knowledge of where and how to invest. Such people can invest in mutual funds because they are managed by experienced professionals. These experts collect money from several investors and allocate this fund to different securities and thereby helping investors generate more gains. The professionals keep an eye on timely entry and exit and also handle all the challenges incurred in the investment horizon. In mutual funds, you just have to make an investment, the rest is taken care of by the professionals who will help you succeed in this field. 

4. Flexibility 

Mutual funds offer the flexibility to invest in smaller amounts. That means you don't need a lot of money to invest in mutual funds. You can invest according to your income and cash flow. For example, if you depend on a monthly salary, then you can select the SIP (Systematic Investment Plan) mode of investment and invest a fixed amount every month or at regular intervals. 

5. Accessibility

Mutual funds are very easy to buy/sell. They are easily accessible and you can buy them from anywhere. There are various Asset Management Companies that offer funds and distribute them through the following channels:
Registrars 
Brokerage Firms 
Mutual Fund AMCs 
Mutual Funds investment online platforms 
Banks 
Agents 

6. Suitable for Every Financial Goal 

This is perhaps the best part of investing in mutual funds. You can start investing with as little as Rs. 500 and there is no limit for maximum investment. The only things investors should consider before investing in mutual funds are their expenses, income, financial goals, and risk-taking ability. In a nutshell, any individual with any financial goal can invest in a mutual fund regardless of his income. 

7. Safety and Transparency

All the mutual fund products have been labelled after the strict SEBI guidelines. This means, all the mutual fund schemes now come with color coding. This color scheme allows investors to determine the level of risk involved in the investment, making the entire investment process safe and transparent. 

The color coding has three different colors to indicate different levels of risk:

The blue color denotes low risk. 
Brown color denotes high risk. 
The yellow color indicates moderate risk. 

Further, in mutual funds, investors are free to verify the credentials of their fund manager. You can cross-check their experience, qualification, history, and so on. 

8. Lower cost

In a mutual fund scheme, funds are pooled from multiple investors, and then this fund is used to buy securities. However, these funds are invested in assets which allows one to save on transaction charges and other expenses as compared to a single transaction. Further, the Asset Management Service charges are also lowered and then divided between all the investors of the scheme. 

9. Tax Savings 

Another benefit of mutual funds is tax saving options. Note that the ELSS funds come with 1.5 lakh of tax reduction per year, under section 80C of the Income Tax Act. Further, all of the other mutual funds are taxed on the basis of the tenure and type of the investment. Moreover, ELSS tax saving funds have the potential to offer higher returns as compared to other tax-saving instruments like FDs, NPS, and PPF. 

Now that you know the advantages of mutual funds, let’s explore the top disadvantages of mutual funds. 

Disadvantages of Mutual Funds

The following are the disadvantages of mutual funds you must know before investing:

1. Entry or Exit Load

Some mutual funds may charge either entry or exit load or both. They levy this charge primarily to maintain their operations and pay staff salaries. Sometimes, the charge may go up to a high 3% of the net investment amount. However, it mostly remains around 1%.

While the load might seem one of the significant disadvantages of mutual funds, funds charging a high load usually offer much higher returns than the average mutual funds. Hence, while the load certainly eats into your profit, you must analyse the fund’s past performance before deciding. 

2. Diversification Might Cause Lower Profits

While diversification might significantly reduce your risks, it may also reduce your profit margin. This may become more prominent if you invest in balanced or hybrid mutual funds. Since these funds invest a part of your capital in equity and the other part in debt, any profit in one might be muted due to a loss in the other. 

3. Difficult Phases

Although long-term investors seldom endure losses, you may have to suffer a capital loss if you accidentally invest before a bad phase. Mutual fund returns are never guaranteed. Hence, it is wise to know a little about the economy and the fund performance before investing. 

4. Liquidity

Fixed maturity and ELSS schemes come with a lock-in period. ELSS usually has a lock-in period of three (3) years. And a fixed maturity plan’s lock-in period depends on the instrument it invests in. For example, if it invests in a bond with a 5-year maturity, you cannot withdraw the units before five years.

5. Capital Gains Tax

Both short-term and long-term capital gains from mutual funds are taxable. If you withdraw your profits before one year from the investment date, you may have to pay a 15% to 20% tax. And, if you withdraw it after a year, you may have to pay a 10% capital gains tax. You may also need to understand the concept of indexation to calculate the taxes efficiently.

Ways of Investing in Mutual Funds

Now that we have discussed the advantages and disadvantages of mutual funds, you may wish to know about the best ways to invest in them. 

So, there are two ways in which you can invest in MFs: SIP and Lump Sum. But what's a better option? Should you choose SIP or a lump sum investment mode? 

SIP Vs Lump Sum — What to Choose? 

A lump sum investment is the one where you're required to invest a particular amount of money only one time. 

Whereas, an SIP (Systematic Investment Plan) allows you to invest in small amounts at regular intervals, say weekly, monthly or quarterly. 

Note that the returns in a lump sum mode depend on the situation of the market. The volatile nature of the market can sometimes adversely affect your returns. On the other hand, SIP yields better returns regardless of the market situation. 

If you want to earn good returns from a lump sum investment, then you can do so by planning and timing carefully. 

Choose Lump Sum investment only if you can stay invested for the long term and have a higher risk appetite. Further, if your risk-taking ability is low and you still want to invest a lump sum amount, then consider debt investments. Here the returns are lower but it is safer than other ways of investing. 

Coming back to SIP, it allows you to reduce the average cost of your investment and hence reduces the level of risk associated with the investment. Further, you can purchase MFs at different prices, which results in reducing the purchase cost and increasing the profits. 

To calculate the mutual fund returns of a SIP, you can easily use any SIP calculators that are available online. 

Final Words - Why Invest in Mutual Funds? 

Investing in the right mutual funds not only helps you gain profits but also helps in securing your financial situation. The money you invest today will lead to a secure tomorrow. Therefore, you should always consider your financial goals and risk-taking ability before making an investment. 

Mutual Fund benefits like cost-efficiency, expert management, tax efficiency, and convenience make it one of the best investment tools for investors. If you're planning to invest in mutual funds, then do so only after conducting proper research and analysis to select the best tools for investment. There are various tools you can use for this purpose like stock screeners, SIP calculators, Income tax calculators, and so on. This approach will help you invest in a safer way. Alternatively, you can also visit 5Paisa, for investing in a safer manner. 

In this article, we have discussed the mutual fund advantages and disadvantages along with the ways to invest in them. Since you know both the pros and cons of mutual fund investments, head to 5paisa to start or excel in your investment journey. We hope this information helps you in becoming a better investor.