Investing in mutual funds is one of the many ways to gain diversified exposure to the financial markets. Since the funds invest in a basket of different market-linked securities, you get the benefit of diversification while continuing to enjoy the potential to get higher returns.
However, as an investor, you need to be aware of the various limitations of mutual funds. Knowing what they are and how to overcome them can help you make the right decisions to achieve your financial goals according to your preferred timeline.
What are the five major limitations of mutual funds?
Mutual funds, in general, have five key limitations. Here is a deep dive into each of these downsides along with potential solutions to navigate each of them:
1. Lack of portfolio customisation
The lack of portfolio customisation is one of the key limitations of mutual funds. Mutual funds are managed by experienced professionals, who are also responsible for choosing the assets that the funds should invest in. Since the control over the portfolio of mutual funds always rests with the fund managers, investors cannot influence or choose the list of securities that the funds must invest in.
For instance, you may find a mutual fund that invests in stocks from many of your preferred sectors. However, a few sectors you’re interested in may not form a part of the portfolio. In such cases, you do not have the power or the freedom to include them in the fund’s assets.
Fortunately, you can easily navigate this limitation. For example, if you find that your preferred mutual fund does not have some stocks that you wish to invest in, you could consider investing in them separately. This way, you can complement your mutual fund investments without straying from your investment objectives.
2. Limited liquidity
While open-ended mutual funds offer redemption flexibility, liquidity can be restricted in certain scenarios. Here is how:
- Lock-up periods: Some funds, particularly fixed-income funds like closed-end funds or tax-saving ELSS (Equity Linked Saving Scheme) funds in India, have lock-up periods. Your money gets tied up for a specific time, typically 3-7 years, limiting immediate access.
- Redemption processing time: Even for open-ended funds, selling your shares does not guarantee immediate cash. It can take a few business days to process the redemption request and receive the funds.
- Market volatility: In extreme market downturns, some funds might restrict redemptions to protect themselves from a surge in withdrawals. This is uncommon but highlights the potential for limited access during market turmoil.
3. No control over costs
Mutual funds collect money from multiple investors and use it to invest in a basket of different securities. The operating costs that the fund houses incur are shared between the investors in proportion to their holdings. Unfortunately, here is where the disadvantage occurs. Investors do not have any control over the costs that mutual funds may incur.
For example, if the expense ratio of a mutual fund is 2%, investors will have to pay 2% of the total value of their holdings annually. They cannot influence, control or reduce the costs that the fund needs to pay.
However, on the upside, the Securities and Exchange Board of India (SEBI) has introduced limits on the expense ratio to prevent mutual funds from levying exorbitant charges. The expense ratio limits for a mutual fund depend on factors like the type of fund and the total assets under management.
4. Exposure
To keep the overall risk in check, SEBI has imposed strict mutual fund investment limits. This ensures that the mutual funds do not overexpose themselves to any particular company, as such concentrated exposure could adversely impact their returns if the company underperforms. For example, equity mutual funds cannot invest more than 10% of their portfolio in a single listed stock. Debt mutual funds, on the other hand, cannot invest more than 10% of their portfolio in investment-grade bonds from a single issuer.
While this restriction is largely a good move for investors, it is still one of the many limitations of mutual funds. Such strict mutual fund investment limits can make it more challenging for fund houses to find good investment options with high return-generation potential.
As an investor, overcoming such a limitation can be much harder. That said, you can consider investing in multiple mutual funds with different or contrasting portfolios to increase the wealth-creation potential of your investments.
5. Dilution
You may already be aware that diversification is one of the best ways to reduce investment risk. Investing in different asset classes and sectors can potentially protect you from the negative impact of adverse market movements.
However, in a bid to reduce investment risk as much as possible, some mutual funds go above and beyond the normal diversification norms. This results in over-diversification and can significantly dilute the return-generation potential of the fund. Furthermore, over-diversification may also lead to high portfolio management costs, which are ultimately passed on to the investors, further reducing their returns.
To avoid this limitation of mutual funds, you must thoroughly evaluate the fund to ensure that the diversification is balanced. Also, remember to select funds with a focused yet diversified approach to investing. This way, you can maximise the benefits of diversification while mitigating dilution.
Conclusion
Despite the limitations of mutual funds, they continue to be one of the most popular ways to invest in the financial markets. If you are planning to invest in a fund, remember to address these five limitations right from the outset. Also, make sure to conduct thorough research into the fund, its constituents, the associated costs and its performance track record. You should also compare different similar funds with one another to make your choice easier and more effective.
