When Are Mutual Funds Considered a Bad Investment?

Mutual funds are known for their wealth-building capacity and higher return potential. Despite the universal knowledge about their profitability, there may be investors who should not invest in mutual funds. Ideally, those who desire guaranteed returns and capital preservation should avoid investing in mutual funds. In this article, we explore why investors may consider not investing in mutual funds and how to adopt a cautious investment approach.

Mutual funds are regulated by SEBI to ensure investor safety. While safe investment avenues, mutual fund investments may not be a wise choice due to the following reasons:

1. Returns are not guaranteed

Mutual fund investments are not for you if you require guaranteed and fixed returns. MFs are market-linked instruments where returns depend on the fund’s performance and market conditions. While you have access to the fund’s historical performance data, past performance does not guarantee future returns. Therefore, if you need guaranteed returns within a fixed timeframe, please do not invest in mutual funds. Rather, you can opt for fixed-income investments like FDs.  

2. Returns may be diluted

SEBI’s regulatory guidelines limit fund exposures to prevent overconcentration in MFs. While this can be beneficial for investors in terms of risk management, it can also result in diluted returns. For instance, equity mutual fund schemes cannot invest more than 10% of their portfolio in a single listed stock, while debt funds cannot invest more than 10% of their portfolios in investment-grade bonds. This restricts funds from investing in assets that offer greater return-generating potentials, resulting in diluted earnings.

3. SIP returns may be negative

SIPs or systematic investment plans are a great way to invest regularly in a disciplined way to build wealth over time. However, investing in SIPs may not always mean positive returns. Your SIP returns may be negative during periods of market volatility. Almost all SIP investments go through such periods during the initial investment years. Investors with a low risk capacity tend to panic during such phases, losing out on rebounds in the long-term. If you cannot withstand such volatility and the possibility of capital loss, avoid investing in mutual funds.

4. High expense ratios and load charges

Investing in mutual funds involves certain fees and charges that can eat away at your returns. For instance, MF schemes charge an annual fee or expense ratio to compensate for the professional fund management and administrative expenses. If the expense ratio of the fund is 2%, you will have to pay 2% regardless of your returns.

5. Liquidity constraints

MFs impose exit load charges (typically 1% of the redemption value) to discourage investors from withdrawing their investments early (before the 1 year mark). Therefore, please do not invest in mutual funds if you anticipate needing your funds early, within 1 year or so. Moreover, ELSS funds also have mandatory lock-in periods of 3 years when no redemption requests are allowed. So, if you need a liquid investment source, consider alternative options. 

• Mutual fund investments do not offer capital protection or fixed return guarantees.
• Your SIP investments can turn negative during periods of short-term market volatility.
• Exiting MF investments involves certain charges and liquidity may be limited for certain funds.

Despite the fact that mutual funds do not offer 100% capital protection or return guarantees, MF investments can offer good wealth-building potential when done right. While several investors assume the magic lies in picking the right fund, this is largely incorrect. Picking the right fund scheme can be instrumental in boosting your overall returns, but the real magic formula is picking the right fund category. In simple words, as an investor, you should focus on picking the right fund category rather than the fund scheme within that category.
 

Let’s break this down further. Primarily, there are two broad categories of funds available in the market, namely, equity funds and debt funds. Equity funds invest primarily in stocks and equity-related assets embracing greater volatility and therefore, bringing you chances of higher returns. Debt funds, on the other hand, invest primarily in fixed-income assets like bonds offering stable returns against lower volatility exposures. Within equity funds, there are large-cap funds, mid-cap funds, and small-cap funds that invest in companies with different market capitalisations. The risk quotient of each fund is different, with small-cap funds having the highest risk exposure. Similarly, for debt funds, there are various subtypes like liquid funds, ultra-short-term funds, long duration funds, etc. Once you understand what each fund type offers, you can choose the right fund category based on your investment goals, risk tolerance, and return expectations.

Like all other investment avenues, mutual funds have their pros and cons. Investors who are looking for fixed and guaranteed returns, risk-free capital preservation, and constraints-free liquidity can consider not investing in mutual funds. However, given the long-term earning potential of MFs, avoiding this investment instrument altogether may be imprudent. Instead of not investing in mutual funds, investors should look for ways of managing the risks associated with market volatility, expenses, and returns through research and diversification.
 

Haven’t started investing yet? Head to the Bajaj Finance Mutual Fund Platform and start your MF journey in a few easy clicks. Choose from 1000+ schemes, compare mutual funds, and estimate returns using our mutual fund calculator to find the ideal match per your goals, time horizon, and risk tolerance capacity.