Advantages and Disadvantages of Mutual Funds

Mutual Funds are perfect for beginners. But you shouldn't invest blindly in mutual funds. Like everything else, you need to know the important advantages and disadvantages of mutual funds before investing your hard-earned money.

Today, we will discuss the 10 most important advantages and disadvantages of mutual funds.

10 Most Important Advantages of Mutual Funds

1. Higher Returns: Mutual funds have a proven track record of generating superior returns than other investment options.

2. Diversification: Diversification is the biggest advantage of mutual funds. When you invest in mutual funds, your investment is divided and invested into various stocks. By doing this, the overall risk of the fund reduces.

   Diversification also increases your chances of earning higher returns as you get to participate in the growth of all top stocks.

3. High Liquidity: Liquidity is when you can easily convert an asset into cash. Open-ended mutual funds Open-ended mutual funds
   In this article, we will cover in-depth information about what are these funds, benefits of investing in open ended and close ended funds, key differences between them, their characteristics, and a lot more which will be helpful for the investors to make informed investment decisions. Read More are highly liquid. So, you can easily sell these funds in case of emergencies.

   In case of equity funds, the redemption proceeds are available in T+2 days. So, if you redeem from ABC Equity Fund on 1st January, then the amount will be credited to your account on 3rd January.

   Debt funds and liquid funds have higher liquidity as the redemption proceeds are available in T+1 days. For example: If you redeem on 1st January, the redemption will be credited to your account on 2nd January itself!

   But Equity Linked Savings Schemes (ELSS), close-ended funds, Fixed Maturity Plans (FMP) have very low liquidity.

4. Professional Portfolio Management: Mutual fund schemes are professionally managed by fund managers. These fund managers are financial experts with years of stock market experience.

   Fund managers do in-depth research of stocks before taking any investment decision. They also constantly monitor the portfolio to ensure optimal returns.

   Historically, actively managed mutual funds have generated superior returns than passively managed funds.

5. Cost Efficient: We all know that when you buy in bulk, the cost per unit reduces drastically. This is known as economies of scale.

   A mutual fund scheme has lakhs of investors. Hence they are able to achieve huge economies of scale. This reduces the fund’s overall expenses.

   Similarly, other expenses are shared among all unitholders. So, the expense per unitholder also reduces. When expenses reduce, the returns earned by investors increase. Hence, mutual funds are one of the most cost-efficient investment options in India.

   Passively managed mutual funds like Index funds carry a lower expense ratio and are highly cost efficient.

6. Perfect for various risk profiles: Not all mutual funds carry high risk. Liquid mutual funds invest in short-term government securities like treasury bills, certificates of deposits etc. This makes liquid mutual funds extremely safe. Liquid mutual funds are perfect for low-risk investors with short-term financial goals.

   Low-risk investors with medium to long term goals can invest in debt funds. Debt funds invest in ‘fixed income’ securities and are much safer than equity funds. Debt funds offer much higher returns than bank fixed deposits.

   Medium-risk investors can invest in hybrid funds, large cap funds, multicap funds etc.

   High-risk investors with long term financial goals can invest in midcap and small cap funds.

   So, there is a unique type of mutual fund scheme to match all types of risk profiles.

7. Tax Benefit: Tax benefit is another huge advantage of mutual funds. ELSS Funds are a special type of mutual fund which is specifically designed to save tax.

   Investment in ELSS funds upto ₹ 1.5 Lakhs qualifies for deduction under section 80C of the Income Tax Act,1961.

   Even Debt funds provide the benefit of indexation if redeemed after 3 years. Equity mutual funds also provide tax benefits. Long term capital gains on equity mutual funds is tax-free if the gains do not exceed ₹ 1 Lakh in a financial year.

8. Highly Convenient: Mutual funds are perfect for both beginners and seasoned investors. Mutual funds offer the convenience of both lump sum investing and Systematic Investment Plan (SIP).

   Investors who have the time, resource and experience to time the market can opt for lump sum investing. The minimum lump sum investment amount varies between ₹ 1,000-₹ 5,000.

   Retail investors should prefer SIPs as they create investment discipline. In a SIP, a fixed amount is deducted every month on a fixed date. By investing across market ups and downs, investors achieve higher rupee-cost averaging. SIPs are perfect for salaried investors who do not have the capital or experience to time the market.

   But there is a smarter way of investing in mutual funds. SmartSIP is RankMF’s proprietary wealth creating order type. A SmartSIP smartly ‘times’ the market to generate superior returns.

   SmartSIP has a proven track record of generating 4%-5% additional returns over regular SIPs. Read more about SmartSIP.

9. Pocket Friendly: One of the biggest advantages of mutual funds is that they are easy on the pocket.

   For example: Suppose you wanted to buy 1 share of Reliance Industries. The current market price of Reliance Industries is ₹ 2,000. To buy 1 Reliance share, you will have to pay ₹ 2,000.

   But you only have ₹ 500 to invest. Unfortunately you cannot buy 1/4th of the Reliance share from the stock market. So you end up not investing in Reliance Industries.

   This does not happen in mutual funds. In mutual funds you can invest ₹ 500 and get proportionate ownership of Reliance Industries.

   You can start a mutual fund SIP with as little as ₹ 500 per month.

10. Highly Safe: Mutual funds are jointly regulated by the Securities and Exchange Board of India (SEBI) and Association of Mutual Funds in India (AMFI). Both these entities work to protect the interest of mutual fund investors. Mutual fund houses, fund managers, investment advisers are strictly managed and monitored to ensure the highest degree of safety.

Most Important Disadvantages of Mutual Funds

1. High Cost: There are no free lunches in this world. Similarly, mutual funds also come with costs in the form of expense ratios. Expense ratio covers fund management fees, marketing and sales costs etc.

   A high expense ratio directly affects your portfolio returns. Investors who prefer a lower expense ratio can invest in ‘index funds’.

2. Misuse of Management Authority: Some fund managers may unnecessarily churn the portfolio. Portfolio churning is constant buying and selling of stocks.

   High portfolio churning increases taxes and other costs. This reduces portfolio returns. Constant churning can also result in your fund manager making poor investment decisions which can lead to substantial losses.

3. comk-in Period: ELSS and FMPs come with fixed comk-in periods. They are highly illiquid and cannot be used during emergencies. Ideally mutual fund beginners should avoid FMPs.

   ELSS funds are a great tax saving option. But only investors who can stay invested for a minimum of 3 years should invest in ELSS funds.

4. Exit Load: Exit load is a penalty charged by the fund house on redemption before a specific period. Different types of funds carry different exit load periods:

   • Liquid funds have an exit load period of 7 days.
   • Debt funds have an exit load period of 30 days - 540 days (credit risk debt fund)
   • Equity funds have an exit load period of 365 days.
   Investors should match their financial goals with the fund's exit load period. For example: If an investor wants to invest for 10 days, then he should invest in liquid funds not debt funds.

5. Over-Diversification: Diversification is a double-edged sword. While it reduces risk, it also dilutes profits earned by investors. At times fund managers invest in too many asset classes. This is known as over-diversification. To avoid this, investors should do goal-based financial planning before investing.

Final Thoughts

This concludes all major advantages and disadvantages of mutual funds. As you can see, advantages of mutual funds far outweigh the disadvantages. Hence mutual funds are the best investment option for investors.

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