Akin to baskets of investments, mutual funds pool money from many individual and institutional investors to buy and sell a variety of securities.
Depending on the stated objective of the fund, it might include stocks, bonds, commodities in different variations.
A mutual fund’s holdings are called its portfolio and each investor owns shares, which are a portion of the portfolio.
When you buy or sell most mutual fund shares, you do it directly with the fund family.
Two of the best-known mutual fund families are Fidelity and Vanguard.
The Pros
When you own shares of a mutual fund, you have a convenient, well-diversified package of many individual investments that would be too unwieldy to manage on your own.
Mutual funds are professionally managed and give you the ability to invest small or large amounts of money, even if you don’t have much financial or investing experience.
The Cons
The pros sound great, but there are two important cons of investing in mutual funds to keep in mind.
1. They have complicated fees that aren’t always transparent
Mutual funds can be expensive to operate and only some of the costs are covered by the proceeds of the investments. Some also have fees either charged annually or at the time you first purchased shares in the fund.
Others minimize the fees in different ways. However, a relatively newer variation on mutual funds has dramatically lower fees, the exchange-traded fund (ETF), which usually follows the performance of an index, but then you pay a commission when you buy or sell shares in the ETF.
2. Share prices are calculated just once a day
Since a mutual fund is made up of multiple securities, its price depends on the value of all the securities in the fund — due to all the moving parts, this overall value is, known as the net asset value (NAV), is only calculated at the end of each trading day.
This might actually be a blessing in disguise because it prevents you from attempting to day trade mutual funds; unless you’re a professional investor, you don’t have access to the kind of technology that makes anything other than a long-term buy-and-hold strategy feasible.
How To Minimize Taxes on Mutual Funds
One way to defer taxes on mutual fund distributions is to own the fund inside of a retirement account, such as a traditional IRA or 401(k). These accounts enjoy tax-deferred growth, which means your profits within them aren’t reported as capital gains.
You don’t get hit with any taxes until you make a distribution from a traditional retirement account after the age of 59½. At that time your profits are taxed as ordinary income, not as capital gains.
Another option is to own mutual funds inside of a Roth IRA. You pay taxes upfront on money you put in a Roth account, but the growth is completely tax-free. That means you could use a Roth account to eliminate taxes on mutual fund distributions.
For more details on the tax treatment of mutual funds, check out the IRS website.
Readers, do you have any experience investing in mutual funds?
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{ 11 comments… read them below or add one }
Thats some great information. If investing in mutual funds is not the way to go then I don’t know what is.I have my mutual funds in my Roth IRA. It seems there are more Pro’s than cons to owning mutual funds. I enjoy the Money Girl Podcasts.
@50plusfinance Thanks for the kind words! Over time, I’ve been selling mutual funds that I own in IRAs and taxable brokerage accounts and replacing them with exchange traded funds (ETFs). ETF fees are literally a fraction of what mutual funds charge. Plus, you don’t have the other two problems I mentioned: phantom gains and once-a-day valuations. ETFs are traded on exchanges just like stocks, so you can track their prices by the minute. And they’re taxed like stocks with no capital gains until you bank a profit. Take a look at ishares.com or proshares.com to learn more about ETFs.
Your article is well-written and researched. I would suggest that you are correct to pursue ETFs, especially if you have a broker like Vanguard that allows you to buy and sell them for even less than the already fractional cost at most places. Even the fees of unmanaged mutual funds are higher, and it has been my experience that many funds require a minimum investment of several thousand dollars. ETFs can be bought in individual shares, making them accessible to the average Joe that doesn’t have the 20-30k necessary to create a diversified portfolio at 2-3k a pop.
Thank you for the great post.
Laura,
I think the capital gains disbursements of a mutual fund are one of their biggest Pros, not a Con.
First, unlike CDs, savings accounts or other interst-based investments, your mutual fund grows in three ways, dividends, capital gains and appreciation. Some years, this helps a lot.
Second, you are taxed on capital gains at the low long-term rate of 15%, which is great for people in higher income tax brackets, which can reach 39%.
Third, if you reinvest your dividends and capital gains, you accumulate addidtional fund shares at the lower adjusted rate. For example, if you own 100 shares of a fund with a $10 NAV and you get a $1 disbursement, you would get close to 111 shares at a $9 NAV. Even though the principal remains the same, more shares is a good thing. It’s like a mini stock split.
I look forward to receiving my distriutions every December and the tax liability is minimal. Often, what happens is the share price quickly returns to the pre-disbursement level and you have more shares. December is usually a great month.
@Bret The annual returns on mutual funds are reduced by the taxes on dividends and capital gains distributions. Additionally, active trading by mutual fund managers racks up transaction costs, which get passed along to investors in fees. After-tax returns are lower for funds with high turnover rates than for those with low turnover. To maximize returns, my recommendation is to choose mutual funds with very low turnover (like index funds) or to own them inside of a retirement account. Another option is to abandon mutual funds altogether and to choose exchange-traded funds, which have none of the capital gains issues and very inexpensive fees.
Laura,
I’m not opposed to index funds. But, like I said in my series on picking mutual funds, I have been able to consistently beat the indexes. And, I would much rather have the dividends and capitals gains and pay taxes on them. I guess everyone has their own M.O.
My portfolio consists of mutual funds, stocks, ETFS in deferred and brokerage accounts. I find that a mix of investments reduce the tax bit and exposure to various types of investments.
If you own mutual funds outside of a retirement account, be prepared for any possible tax liability this year.
thats true
There’s definately a great deal to learn about this
issue. I really like all the points you made.
I think this article is enough to understand the pros and cons of investing in mutual fund, its been a great content for me.
ETF’s are a sensible alternative to mutual funds and many mutual funds underperform the benchmark indexes.