Potential Pitfalls for Investing in Mutual Funds

While mutual funds are probably the most sure method of creating long-term wealth, they are not without their drawbacks. All types of investments have their drawbacks, but it seems that mutual funds allow the greatest opportunity in return for the least amount of risk.

The first drawback that probably scares most people away from mutual funds is that the majority of mutual funds return less than than the average annual return of the stock market. This is true, but if one continually pays attention to his or her fund, selects a good manager, avoids the fees, and is willing to be patient, it is very possibly to find mutual funds that return the market average or a little better.

The next major drawback of mutual funds that most people are probably not aware of is the insane amount of fees some funds charge. Some funds charge a fee up-front when someone applies to open an account; this is called a front-load, and front loads can run anywhere from 4-5.75%. This means that before a person's money is even invested, 4-5.75% of it is taken away. Likewise, mutual funds might also charge a back-load, which means that when someone sells his or her shares, the company will again take a high percentage, usually in the range of 4-5.75%. This should not force anyone to be scared of investing with mutual funds. Most mutual funds do not operate in this manner, and the SEC requires these numbers to be disclosed to prospective investors. The reasoning behind these purchase and sales charges is that these mutual funds claim to offer a level of performance that is much higher than no-load funds, but there is no evidence anywhere to support that, and there is no good reason to invest in a mutual fund with a load, period. There are other mutual funds that invest in the same, or similar things, which provide better returns, and do not charge a load. Most mutual funds do not charge a load, and those that do seem to not be confident that they can perform well on a consistent basis.

The other thing to watch out for is a change in fees. Mutual funds cannot retroactively change fees such that if one purchased 1000 shares a year ago and was not charged a front-load, that instead now he or she can be charged a front-load for that purchase in the past. However, they can say that starting a few months in the future, any shares purchased on or after such a date will be subject to a front or back load. The companies are required to notify investors in writing, so investors should just continue to pay attention to see if there are any changes in fees.

The final item to note is the expense ratio, which very generally is what it costs to operate the fund; this includes the manager's salary, probably the salaries of the other staff, and many other expenses. A good fund operates with a 1.25% expense ratio or less; some funds can have expense ratios in the 2-3% range, and in most cases, these are funds to avoid. The expense ratio is just another fee that eats into the overall returns of a mutual fund, and therefore it is wise to choose funds with smaller expense ratios. The Vanguard family of funds is famous for its incredibly small expense ratios, which often range in the .2-.4% range.

Overall, mutual funds are an awesome way for someone to invest his or her money and make the money work for him or her. But, like anything, they have their traps and pitfalls. If one falls into these, he or she is very likely to find returns below the market average. However, these traps can be avoided if one pays attention to his or her fund by reading the prospectus and any other communication sent to him or her by the fund.