I've heard in passing when discussing investments, "oh, you're crazy to invest in mutual funds". I didn't want to seem like I didn't understand at the time. What are the downsides of investing in mutual funds compared to other investments? Are they really that bad?

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    As opposed to what alternative? – bstpierre Aug 5 '10 at 23:00

All mutual funds are not created equal; some invest in bonds while others in equities. Some highlight different sectors or have an international scope. Regardless of the mutual fund here are some general reasons why you might want to avoid them:

  1. They are expensive. Mutual funds regularly charge between 1-3% in yearly fees. Sometimes even more. So that means if the fund increases in value by 5% in one year and the annual fee is 3%, you only net a 2% increase. Another example, if the fund only increases by 1% and the annual fee is 2%, you're actually losing 1% of your money.
  2. Mutual funds are not priced continuously throughout the day. Unlike stocks, ETFs, and other securities that are priced constantly during the trading day, mutual funds are only priced once a day (at the end of the day). This means that is impossible to day trade with mutual funds. Because of this, the investment time horizon must be longer than other securities that are constantly priced.
  3. There are alternatives! ETFs (exchange traded funds) have become increasingly popular over the past decade. They are cheaper than mutual funds by sometimes a factor 10. So a mutual fund may charge an annual fee of 3%, while an ETF may only charge a 0.3% annual fee. Like stocks, they are priced constantly during the trading day. This means that they can be used for day trading. For example, people used SPY (tracks the S&P 500) and GLD (tracks the price of gold) to easily bet on daily moves in price. ETFs also allow you to invest in commodities or currencies without having to transact in those markets directly.

So to summarize, there is nothing wrong with mutual funds, but there are better alternatives. For the reasons listed above, I would try to investment in an ETF before a mutual fund (given that they have similar investment characteristics).

Here's the section of the Wikipedia article on ETFs explaining their advantages: wikipedia article

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    I don't think the fees argument holds much water for ETFs vs. regular mutual funds. The fees in ETFs can be high, and mutual fund fees can be very low (e.g. Vanguard funds). The fee argument is really more for actively managed funds (which have higher fees) vs. index funds (which have much lower fees) – Eric Petroelje Aug 5 '10 at 23:41
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    As a class, on average, ETF vs mutual funds the ETFs probably have lower fees. But like Eric said, there are outliers that you have to watch out for. I wouldn't make a blanket statement "ETFs good, mutual funds bad". Mutual funds had image problems a few years ago related to pricing scams. ETFs are new enough that we haven't (to my knowledge) seen a big scandal, but we (unfortunately) probably will before too long. – bstpierre Aug 6 '10 at 2:42
  • Great answer, thanks for this info. Just want to add a point about the fees: look for the term "no-load." That means it's a fund without transaction fees (there are still management fees though.) – jhocking Apr 8 '11 at 15:32
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    I'd argue that the day-trading ability of ETFs is a double-edged sword. From what I've read in the literature, a common beginner's mistake is to trade too often, incurring high transaction costs. For long-term investing, there should be no need to care about intra-day fluctuations. – Lagerbaer Jan 4 '13 at 19:20

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