The Drawbacks of Investing in Funds

By Eric Tyson

Although the best funds can be great, there are also drawbacks, and you need to know them, too. After all, no investment vehicle is perfect, and you need to understand fund negatives before you take the plunge.

Still, the fund drawbacks that we’re concerned about are different from the ones that some critics like to harp on. Here’s our take on which fund drawbacks you shouldn’t worry about — and which ones you should stop and think about a little more.

Don’t worry about these funds

If you’ve read some articles or heard some news stories about the downsides of funds, you may have heard of some of the following concerns. However, you shouldn’t let them trouble you.

  • The investment Goliath: One of the concerns you should know about is the one that, because the fund industry is growing, if stock fund investors head for the exits at the same time, they may get stuck or trampled at the door. You could make this argument about any group of investors, including institutions. Little evidence suggests that most individual investors are prone to rash moves. Funds have grown in importance simply because they’re a superior alternative for a whole lot of people.
  • Doing business long distance: Some people, particularly older folks who grew up doing all their saving through a local bank, feel uncomfortable doing business with a company that they can reach only via a toll-free number, the mail, or a website. But please recognize the enormous benefits of fund companies not having branch offices all over the country. Branch offices cost a lot of money to operate, which is one of the reasons bank account interest rates are so scrawny.
  • Fund company scandals: Several funds earned negative publicity due to their involvement in problematic trading practices. In the worst cases, some fund managers placed their own selfish agendas (or that of certain favored investors) ahead of their shareholders’ best interests. Rightfully, these fund companies have been hammered for such behavior and forced to reimburse shareholders and pay penalties to the government.

However, the amount of such damage and reimbursement has been less than 1 percent of the affected fund’s assets, which pales in comparison to the ongoing drag of high expenses. The parent company responsible for an individual fund should be an important consideration when deciding which funds to entrust with your money. Avoid fund companies that don’t place their shareholders’ interests first.

Worry about these funds (but not too much)

No doubt you hear critics in the investment world state their case for why you should shun funds. Not surprisingly, the most vocal critics are those who compete with fund companies.

You can easily overcome the common criticisms raised about fund investing if you do your homework and buy the better available mutual funds and exchange-traded funds. Make sure that you consider and accommodate these factors before you invest in any fund:

  • Volatility of your investment balance: When you invest in funds that hold stocks and/or bonds, the value of your funds fluctuates with the general fluctuations in those securities markets. These fluctuations don’t happen if you invest in a bank certificate of deposit (CD) or a fixed insurance annuity that pays a set rate of interest yearly. With CDs or annuities, you get a statement every so often that shows steady — but slow — growth in your account value. You never get any great news, but you never get any bad news either (unless your insurer or bank fails, which could happen).

Over the long haul, if you invest in solid funds — ones that are efficiently and competently managed — you should earn a better rate of return than you would with bank and insurance accounts. And if you invest in stock funds, you’ll be more likely to keep well ahead of the double bite of inflation and taxes.

If you panic and rush to sell when the market value of your fund shares drops (instead of holding on and possibly taking advantage of the buying opportunity), then maybe you’re not cut out for funds. Stock fund investors who joined the panic taking place in late 2008 and early 2009 and sold got out at fire-sale prices and missed out on an enormous rebound that took place beginning in early 2009.

  • Mystery (risky) investments: Some funds have betrayed their investors’ trust by taking unnecessary risks by investing in volatile financial instruments such as futures and options (also known as derivatives). Because these instruments are basically short-term bets on the direction of specific security prices, they’re very risky when not properly used by a fund. If a fund discloses in its prospectus that it uses derivatives, look to see whether the derivatives are used only for hedging purposes to reduce risk instead of as speculation on stock and bond price movements, which would increase risk.
  • Investments that cost an arm and a leg: Not all funds are created equal. Some charge extremely high annual operating expenses that put a real drag on returns.
  • Taxable distributions: The taxable distributions that funds produce can also be a negative. When fund managers sell a security at a profit, the fund must distribute that profit to shareholders in the fund (dividends are also passed through). For funds held outside tax-sheltered retirement accounts, these distributions are taxable.