Limitations of Mutual Funds:
When it comes to investing, understanding the limitations of mutual funds is essential. While most people have heard the statement “Mutual Funds are subjected to market risk,” there are other limitations of mutual funds that we often overlook.
In this blog post, we will explore two key weaknesses of mutual funds that every investor should know about.
By understanding these limitations of mutual funds, you can make informed decisions about your investments. So, let’s dive in and discuss these limitations in simpler terms.
Limitation 1: Cash Position Maintenance:
When you invest in mutual funds, it’s essential to read the offer document carefully. This document tells you how much cash the mutual fund keeps on hand and how much it invests in the market.
The cash position is important because it helps meet the needs of investors who might want to withdraw their money after a certain period.
Typically, mutual funds keep around 2-5% of the total investment as cash. In some cases, like with liquid funds, they need to keep more cash (around 20%) because these funds are meant for short-term investments.
By keeping cash, mutual funds can take advantage of buying opportunities in the stock market. However, this practice limits their potential during market downturns, as they might miss out on good buying opportunities.
The amount of cash a mutual fund keeps is influenced by the money coming in and going out from investors.
When the market is doing well and more people invest in mutual funds, the funds receive more money.
In such cases, if the fund manager invests all the incoming money in stocks without keeping cash, they might end up buying stocks at higher prices.
On the other hand, during market downturns, when investors withdraw their money from mutual funds, the funds are forced to sell stocks at lower prices, resulting in losses.
So, the limitation lies in mutual funds being obligated to stay invested even when the market conditions aren’t favorable.
Limitation 2: Managing Large Amounts of Money:
As mutual funds accumulate a lot of money, they face a unique challenge—managing large sums effectively.
This challenge is not limited to mutual funds alone; even Warren Buffett, a famous investor, acknowledges this limitation through his company Berkshire Hathaway.
In 1999, during a shareholder meeting, Buffett talked about the difficulties of managing larger amounts of money effectively.
When mutual funds have billions of dollars to invest, it becomes challenging to find suitable investment opportunities, especially in smaller companies with potential for growth.
Mutual funds often have restrictions on investing heavily in small companies because they don’t want to become majority owners.
For example, if a mutual fund manages billions of dollars and finds a promising small company worth a few hundred crores, it can’t invest a lot without owning a majority stake, which goes against its investment strategy.
As a result, mutual funds miss out on the potential high returns that small companies can offer.
Retail investors, like you and me, have an advantage because we can analyze stocks ourselves and invest in smaller companies without facing these limitations.
This constraint limits the ability of mutual funds to generate exceptional returns as they manage larger and larger amounts of assets.
Conclusion:
Understanding the limitations of mutual funds is crucial for investors. While we have discussed two major limitations in this post, it’s important to remember that these limitations don’t negate the potential benefits of mutual funds entirely.
Also, Read | Why Mutual Funds Are Better Than Stocks: A Comprehensive Guide
Every investment product has its pros and cons, and it’s important to consider them when making investment decisions.
By being aware of these limitations, you can make informed choices about when to enter or exit mutual funds.
Remember to conduct thorough research, analyze your options, and adopt a diversified investment approach to achieve your long-term financial goals.
So, take the time to carefully evaluate your investment options and make decisions that align with your financial objectives.
Remember, investing is a journey, and by understanding the limitations of mutual funds, you can navigate the market more effectively.