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In our previous article, we gave you an overview of mutual funds and discussed the various types of mutual funds.
Investors interested in the stock market but unable to invest their money and make profits in it due to a possible lack of knowledge, or fear factor could opt for mutual funds. However, an interested investor who wishes to invest in the mutual funds, should be aware of its limitations before investing.
Before making an investment in mutual funds, investors should know that mutual funds are subject to market risks and the offer documents should be read carefully before making any investment.
So, before you take any decision, let us walk you through the possible limitations associated with mutual funds.
Mutual Funds Limitations
- In a mutual fund document, the cash position that the mutual fund will be maintaining on an average is mentioned along with the money amount that would be invested into the market. The objective of maintaining the cash position is to meet the fund requirement of any investor, which requires money urgently. It totally depends on the fund manager to set the percentage amount.
Sometimes, the fund manager could even maintain the cash position up to 10% if he sees buying opportunities in the market, as these funds could be beneficial in this case. Now, this also has some advantages as well as disadvantages.
The advantage is that, if the stock market is doing good and all the money is invested in the market, then the mutual fund also performs well and generates good returns. On the other hand, if all the money is invested and the market is not doing well, buying opportunities for mutual funds almost tends to zero.
Now let’s understand this theory better.
Money in a mutual fund comes from investors. When the market is doing well, more and more investors invest in the market in mutual funds. When more investors are interested in mutual funds, more money starts coming. Since the fund is not required to keep more in cash, most of the fund is put in the market. As the market is at a higher position, the funds will be purchased at a higher price.
Secondly, in a case when the economy is not doing well, investors are withdrawing their money from the mutual funds. In this case, the mutual fund would also be required to withdraw money from the market. They do not have the option to hold money in cash which an investor has.
- The second limitation of the mutual fund is the problem of large sums of money. To understand this, let’s suppose, a mutual fund is required to spend $10 million and it gets a small company with huge potential to grow in the future. The total asset under management of the mutual fund is $100 million. The total valuation of this company is $2 million, then, in that case, the fund cannot be invested in that company.
Let us consider that $1 million is invested in the company and the mutual fund has 50% stake in it. Now, even if mutual funds make a profit of 50% by investing in the stocks of that company, it would have a very small contribution to the overall return of the mutual funds. Thus, the drawback is that mutual funds are designed in a way, that it cannot invest in the smaller companies.
Things Which Investors Should be Aware Before Investing in Mutual Funds
After having a fair understanding of the limitations of mutual funds, an investor needs to adhere to the below before selecting the right mutual fund.
Define the objective of your investment
If an investor is interested in investing in mutual funds, it is important that the investor sets the objective of his investment and accordingly plans to invest money towards the goal. For example, the objective of the investment could be a child’s education or retirement earnings and accordingly make dedicated savings to achieve long-term goals.
Existence of the mutual fund
It is also very important for an investor to confirm that the mutual funds in which they are planning to invest has been in the market for quite a decent time frame. Existence in the market helps an investor in deriving an idea about its past performance, stability and the volatility. Investing in a newly established mutual fund could be a risky business.
Fund Manager’s Background
The experience of the fund manager also counts a lot when you plan to invest in a particular mutual fund. An experienced and skilled fund manager will give you confidence that the money is in a safer hand.
Review of the mutual fund scheme as well as the investment style
The investment style of the mutual fund is also an important criterion while selecting a mutual fund. This should minutely be observed whether the scheme of the mutual fund matches the end objective and the risk profile.
Asset under Management
Asset under management is another parameter which gives an investor a fair idea about a mutual fund. A mutual fund whose asset size is large gives investor confidence as more investors have also invested in that fund.
Know the type of mutual fund money would be used
It is also important to know about the type of mutual fund, whether debt fund, equity fund or the hybrid fund in which the invested amount will be used. An investor with a high-risk appetite can opt for equity mutual funds while the conservative investor can go for debt mutual fund. An investor with moderate risk-bearing capacity can opt for hybrid mutual funds. The investment objective plus the risk appetite helps one in making better decisions.
Inflation rate
Inflation rate should also be kept in mind before deciding in which mutual fund the investor would like to invest the money. In case the inflation rate of any country is 10%, and the mutual fund provides a return of 8%, then it is not ideally the right choice.
Historical performance of the stock
Past performance is one of the important parameters while examining a mutual fund. It should not be the only criteria for selecting a mutual but should be clubbed with other metrics and objectives.
While looking at the past performance, it is important to look for consistency of the return provided by the mutual fund and the fund’s performance in different cycles.
Check the Volatility of the fund
In the above point, we highlighted that the investor should see the performance of the mutual fund during different time frames. Along with this, the return should be compared with a benchmark which could either be an index or any fund lying in the same category.
Entry and Exit Load
Entry and exit load should also be checked while analysing a mutual fund. Entry load refers to the amount which an investor needs to pay during the time when he/she buys the fund. On the other hand, the exit load is just the opposite of entry load, where an investor needs to pay the amount for the mutual fund which he/she sells within the stipulated time frame.
In such a scenario, investors prefer to invest in mutual funds which have low entry and exit load.
