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6 Advantages and 6 Disadvantages of Mutual Funds vs ETFs – Why Mutual Funds are a Bad Investment

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Mutual Funds are one of the most common ways to invest in equity and debt and a large mutual fund industry is involved in this endeavour.There are large number of high paying professions in Wall Street which depend on the mutual fund industry which include stock brokers and sales persons.However the amount of cost of mutual funds is not proportionate to the gains they give out.This is the reason that Exchange Traded Funds (ETFs) and passive funds which have lower expense ratios and expenses are gaining billions of dollars in money.The reason is that a large number of mutual funds regularly underperform the benchmarks.This has caused massive heartburn amongst investors who have to pay large amounts of fees for the services of the professional fund managers.This has been the trend historically and found amongst numerous countries as well.Besides the costs of the sales and distribution of these mutual fund with their hefty commissions also falls on the investor ultimately.However the prevaling custom of investing in mutual funds is not easily broken despite the underpformance of the mutual fund industry.Most of the advantages of mutual fund can now be found in ETFs which have much lower costs.They also remove the disadvantages such as the possibility of a bad mutual fund manager.

Advantages of Mutual Funds

1) Diversification – One of the most important way of improving returns at lower risk is through diversification of stocks and bonds.However buying a number of stocks and keeping track of each of them is impossible for a normal person.Mutual Fund helps in this by allowing you to buy a large number of assets and subdividing it into units which are small and easily bought

However ETFs these days allow the same function as it invests in an index of financial assets.They also remove the discretion of individual managers since they are passive and just follow the index which is mostly fixed

2) Convenience – Mutual Funds are easily bought and sold and there exists a massive industry which makes it possible to do so.It is as easy as buying a share or a bond.

ETFs are even more convenient to buy than a mutual fund since they are traded on exchanges the whole day unlike mutual funds which can only be bought and sold after the close of the markets

3) Full Time Investment Managers – This is a double edged sword since investing is a tough business and most fund managers don’t meet the mark.Even top fund mangers have known to fall badly.Its a business of luck since you are more likely to find a bad fund manger than a good one

4) Active Management of Companies,making them Investor Friendly – Some mutual funds have activist mangers which can change the way a company operates by making it more investor friendly.However the vast majority of funds don’t do this reducing their advantage.A large AMC like Fidelty can exercise enormous influence over the company management but they have failed to do that.Some Hedge Funds and big Investors like Ichann have done a lot to improve the practises of badly performing companies.

5) Versatility – Most Mutual Fund Companies come up with a huge variety of mutual funds which allow you to make bets on different asset classes and types like mid cap funds,sector specific funds etc.However again they can be double edged as mutual fund investors generally don’t understand the risks and benefits.They usually lose out.

ETFs also offer the same as their are now hundreds of ETFs which follow most asset classes though these days the number of ETFs has exceeded their value

6) Liquidity  – Most Mutual Funds can be easily be bought and sold unlike some shares and bonds which are illiquid.Note its easy to invest in illiquid financial assets like real estate through mutual fund like REITs

ETFs are also in general quite liquid and they too allow you to invest in tough to invest assets like international stocks,currencies and bonds.

Disadvantages of Mutual Funds

1) Underperformance – Most mutual funds don’t perform as well as the benchmark index which is a crime in my view since you are paying a lot of money for these mutual funds to do better.Also in the long run even a 1-2% underperformance can make a huge difference to the end result due to compounding

2) Fees – Most mutual funds charge much higher fees than ETFs since they have to pay the fund managers,analysts and sales people.

3) Cases of Fraud and Front Running – These things are also not unheard of as these funds command billions of dollars and can engage in illegal activity like placing orders on their own account.ETFs are mostly passive and less chances of engaging in fraud.

4) Transaction Costs – These funds have higher tranactions costs as they have to move enormous sum of money into stock which can change the bid and ask spreads.Note ETFs have lower costs than Mutual Funds

5) Lack of Flexibility – You cannot change the investment pattern of a mutual fund even if you think its foolish.Mutual Funds also have rigid rules which sometimes makes them fail to take advantage of market conditions.Mutual Funds in some countries can’t short stocks which would make sense in a bear market.They have to be invested most of the times even though they can go to cash.This has made hedge funds more popular

6) Dependence on Individuals – Good Mutual Funds are dependent on star managers who can easily leave and this make a good mutual fund bad as it depends on the talent of the individual.Some funds have lost enormous amounts of money after a good fund manager has left

Why Mutual Funds are a Bad Investment

Mutual Funds are a bad Investment as they keep under performing and charge high fees.Mutual Funds are more concerned with raising their AUM rather than performance.It matter more to raise their assets as it gives more profits.Mutual Funds are only concerned with relative performance and not with absolute performance.If most of the mutual fund industry does badly and the mutual fund does not do well then the manager is not fired.This leads to herd bias and leads to chronic bad performance.Fund manager incentives are also not aligned well as they don’t have to personally invest in the mutual funds unlike hedge funds where the managers also have to put “skin in the game”.While hedge funds too have their problems,the recent trend of assets moving away from mutual funds shows that this financial class has become a Bad Investment.

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Abhishek Shah

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