What are the five pitfalls of mutual funds?

Mutual fund companies collect monies from investors, and this pooled amount is deployed to purchase a variety of money market instruments like stocks, debentures, bonds, and government securities. The spread minimizes capital loss risks even as fixed-income securities deliver a steady income. Any form of investment carries its own risk factors, and mutual funds are no exception to this, including the expense ratio in mutual fund. We discuss some of the risks below.

Capital risk—The undeniable reality is that you could lose a part or even full, investment amount in volatile markets. Fund managers make investments in good faith, taking into account the prevailing market conditions.

Inflation risk—-If the returns on your investment do not keep pace with the rate of inflation, the numerical value of the investment may remain intact, but the purchasing power reduces.

Interest rate risk—-Rising interest rates could lead to a decline in the value of your mutual fund investment holding. The fixed-income securities will no longer be attractive, though they are safe and are generating returns.

Currency risk—-In investments made in securities in a different currency, there is the danger of currency exchange fluctuations eating into the returns.

Credit risk—-In a mutual fund, credit risk could arise when the issuer of a debt security defaults on his/her payments on maturity dates. This will reduce the portfolio value, thus decreasing the net asset value. The market value of the investment in this mutual fund automatically takes a hit.

We will also discuss some of the other drawbacks of mutual funds as investment vehicles.

High expense ratio in mutual fund

In mutual funds, the expense ratio is the fee paid by the investor to the mutual fund company to manage the portfolio. The fee is deducted from the mutual fund’s earnings, and naturally, a higher expense ratio will mean lesser returns for the investor. A similar fund with similar earnings but with a smaller expense ratio will be more attractive to the investor.

In India, expense ratios tend to be higher given the comparatively smaller market than in developed countries and the higher regulatory expenses and compliance costs in our country. However, the Securities and Exchange Board of India (SEBI) has been taking some constructive steps to lower expense ratios. The market regulator says fund houses should categorize mutual funds according to their investment objectives and risk profiles. The categorization will provide investors a true picture of the expense ratio and also give them the option to choose a scheme more suited to them.

Undiversified portfolio

The very idea of a mutual fund investment is to spread one’s investment across a diversified portfolio. But when investors put all their monies into mutual fund schemes that focus on a single sector or asset class, they run the risk of an undiversified portfolio. When the sector or the asset class performs poorly, the entire fund’s corpus takes a beating. It would be prudent to spread one’s mutual fund investments across different kinds of mutual funds comprising a variety of investments.

Timing market fluctuations

Timing needs much skill, experience, knowledge, and perhaps luck too. Knowledge implies knowing the market trends and the capacity to understand the economic indicators. It is impractical to imagine that one would be able to predict the right time to sell/buy and take timely action each time one transacts.

Timing calls on you to not just buy or sell at the right time but also when to buy back what was sold. Timing could also mean holding on to security till better times unfold. In the long run, the “buy and hold” approach often delivers greater returns than trying to time the market frequently.

Lack of transparency

Though SEBI regulations mandate proper disclosures, there have been occasions where mutual funds have not been transparent enough. The opaqueness may have its roots in the following:

• Complexity in fund structures—Complex structures could make funds confounding and confusing to investors. The percentage-wise allocations of funds across different asset classes and sectors, along with the discretionary authority bestowed upon the fund manager to tinker with these allocations, could be too complex even for a seasoned investor.
• Hidden fees—Sometimes, fund houses bury their fee in small print, but when they kick in, the investor loses out on his returns. The investor may not be able to compare these charges with that of other funds. Nowadays, more mutual fund companies are becoming aware of this because of the SEBI guidelines.
• Insider trading—There have been instances where fund managers have initiated trades based on “inside tips” and unconfirmed reports not obtained from the public domain. These are not healthy practices and could lead to financial losses and, worse, legal troubles.
• Lack of proper disclosure of portfolio holdings, which could happen in two ways:

1. Incomplete disclosure, where investors don’t have the full details of all investments. The incompleteness can be deliberate or accidental. Deliberate incompleteness is a greater offense as it exposes a lack of integrity, while accidental incompleteness amounts to negligence. Either way, it affects the investor.
2. Delayed disclosure where the data shared may not be relevant anymore. It would be like reading an old newspaper for the latest news.

Conclusion

In spite of the pitfalls, mutual funds can always be a viable investment option if you invest with proper care and attention.

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