5 reasons not to invest in mutual funds

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Traditionally, mutual funds have stood as a go-to investment strategy for those looking to grow their wealth without the effort of stock-picking.

Mutual funds promise diversification, professional management, and the simplicity of having someone else navigate the complexities of the market and are often represented as a good vehicle for “hands-off investing.”

If you walk into most banks in Canada and are looking to invest money, the companies will usually recommend that you buy a mutual fund.

However, in my experience and if you dig into the data, mutual funds often aren’t the golden ticket they're made out to be, especially in Canada. Below, I’ll explain a bit more about how mutual funds work and explain why they may not be the best choice of investment.

How do mutual funds work?

Mutual funds are investment vehicles that pool money from multiple investors to buy a diversified portfolio of stocks, bonds, or other securities.

They’re managed by professional fund managers, who are responsible for growing the portfolio to reach benchmark goals (or to at least try).

Those who invest in mutual funds buy shares or units, which represent a portion of the holdings of the fund. The value of these shares fluctuates with the performance of the fund's underlying assets.

Profits are earned in the form of dividends on stocks and interest on bonds held by the fund, and from capital gains when securities in the fund's portfolio increase in value.

Investors can buy or sell their shares at the fund's current net asset value, which is calculated at the end of each trading day.

Reasons to avoid mutual funds

At first glance, mutual funds often seem like a good investment idea. You would think that a professionally managed investment portfolio stands a higher chance of performing well over the long term than a non-trained investor putting together a random portfolio.

While that can be true, I usually suggest that people invest in Exchange-Traded Funds (ETFs) over mutual funds, as they come with lower fees, give the investor more control over their liquidity, and often outperform traditional mutual funds.

Here are five reasons to consider options other than mutual funds:

1. High fees and expenses

Mutual funds in Canada are notorious for their layers of fees, such as management fees, administrative costs, and others that can significantly reduce your investment returns over time.

These fees are charged regardless of the fund's performance, meaning your investment has to overcome these costs before generating any real profit.

When you compare this to lower-cost alternatives like ETFs or index funds, which often come with much lower expense ratios, the impact on your long-term returns can be substantial.

ETFs and index funds replicate market indices, offering a cost-effective way to achieve diversification without the hefty fees associated with mutual funds.

2. They often underperform expectations

Mutual funds frequently fail to outperform their benchmarks. Despite the expertise of fund managers, the reality is that a majority of mutual funds in Canada do not beat the market indices they aim to surpass.

This underperformance can be attributed to high management fees, market volatility, and poor management strategies.

3. Limited control over investment choices

Investing in mutual funds means putting your trust in fund managers to make the right decisions on your behalf, limiting your control over individual investment choices within the fund.

While some investors might appreciate offloading these decisions, it can be frustrating for those who prefer to have a say in where their money is invested. The only choice you have is picking which mutual fund you want to be in, and if the fund manager underperforms, you won’t be able to do anything about it.

4. Taxation issues

Mutual funds are prone to creating tax inefficiencies through capital gains distributions. These occur when fund managers sell assets for a profit, and these gains are distributed to investors, triggering taxable events.

Even in years when the overall fund performance might be down, investors could still owe taxes on these distributions, creating an unwanted tax burden.

This aspect makes mutual funds less attractive for tax-conscious investors, who might prefer holding individual stocks or ETFs that offer greater control to the investor, as they get to decide when they want to realize their capital gains.

5. Liquidity issues

Lastly, mutual funds are far less liquid than compared to investing in an ETF. Mutual funds are traded only once per day at the closing Net Asset Value (NAV), while ETFs are traded throughout the day on stock exchanges, allowing for real-time price adjustments and advanced trading strategies.

Mutual funds can also have lock-up periods, during which investors aren’t allowed to take their money out of the fund.

What should you invest in instead?

In past times, when investors didn’t have the same direct access to the market that they have today, mutual funds stood as a simple, relatively hands-off investment vehicle.

However, thanks to the internet, the average consumer investor today can directly invest in ETFs, index funds, or build their own portfolio of stocks to mirror top-performing ETFs -- all without the management fees, lock-up periods, and restrictions of dealing with a mutual fund.

Christopher Liew is a CFA Charterholder and former financial advisor. He writes personal finance tips for thousands of daily Canadian readers on his Wealth Awesome website.