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Investing for The Wealthy

What You Need to Know Before Investing in a Pre-Existing Portfolio


One of the more-popular investment options available today is investing in an index or mutual funds. They have become popular alternatives to individual equity trading since mutual funds generally include several stocks and a greatly-reduced fee schedule.
However, while some of these risks are obvious, most investors wouldn’t consider a number of other risks until after they’ve purchased a mutual fund.
This article will discuss a few of the things a potential investor should know prior to entering a pre-existing portfolio to mitigate some of the common risks and ultimately produce better yield.

What is a Mutual Fund?

A mutual fund is a collection of money that investors pool in the interest of a joint financial venture. A fund manager oversees this, attempting to ensure the return on investment is maximized for all the fund’s contributors.

Because a mutual fund is a collective, all of the contributors, shareholders, or investors either benefit or incur losses equally. Although appealing to many investors, others dislike this aspect of mutual funds so they prefer to be on their own. Being a mix of bonds, equities, and other securities, index and mutual funds tend to be less risky than individual equity or bond investment.

What is an Expense Ratio?

One advantage of a mutual fund versus an individual investment is that the fund’s expenses are shared by the collective. This primary expense – the account and management fees for the fund – is expressed as an expense ratio, usually ranging from about 20 to 200 or so.

An expense ratio of 110 would indicate that the management firm extracts a fee of 1.1% against the annual value of the account. Each member of a given fund pays their corresponding portion to cover this fee.

The published expense ratio on a mutual fund covers a number of expenses, including management fees, custody costs, administrative costs, marketing costs, and sales incentives paid to advisors.

Moreover, this ratio doesn’t include the cost of trading associated with executing buys and sells within the portfolio. This is a separate fee that investors will need to account for and potentially investigate.

In short, a mutual fund generally refers to a managed pool of equities or securities, as well as index mutual funds constructed to track a given market.

What is an Index Mutual Fund?

An index mutual fund is a specific type of fund constructed to match or track most of the individual components of a market index. The most commonly-copied index is the Standard & Poor’s Index 500 (S&P 500), which most investors believe best represents the current U.S. equities market.

An index mutual fund provides ample benefits, including exposure to a broad number of markets and sectors, relatively-low operational costs, and low portfolio turnover. Indices such as the S&P 500 are considered to be broad-market indices because they tend to reflect the movement of the entire market.

Index mutual funds have perhaps become the mostly commonly-used type of mutual fund, although mutual fund companies have other alternatives available for investors.

Why Invest in a Mutual Fund?

A mutual fund is a form of collective, passive investing in which an investor pools resources with a number of other investors. This is overseen by one or more fund managers.

Passive investing is an approach in which investors maximize their eventual returns by keeping buying and selling to a relative minimum. The most-popular forms today are probably index mutual funds and bond mutual funds. This is because investors are still seeing strong returns while reducing management fees.

While active trading requires investors to continuously buy and sell – and thus incur associated fees – most passive investments including mutual funds work better with minimum changes to the contents of the fund.

To use index investing as an example, an index is designed to mirror a given market. In most cases, managers are not constantly buying and selling equities. Because there is no significant trading involved, investors can realize notable savings in management fees.

For those who do not love scouring market reports for the latest changes, passive investments such as mutual fund investment can be an effective way to supplement or even increase income.

Ultimately, purchasing a mutual fund has a lot of advantages for an investor who does not want to be overly-active in managing an investment account. For those who are willing to delegate to experienced fund managers and don’t mind playing with others, mutual funds can make a lot of sense.

Disadvantages of Buying a Mutual Fund

While the advantages of buying a mutual fund have been established, there are a number of potential drawbacks that need to be considered:

  • The positions held today may have been purchased on old or outdated information.
  • An investor may pay taxes on profits that the investor didn’t directly receive.
  • Actions of others can drive down the value and change the direction of the portfolio. An investor doesn’t always get a clear picture of trading patterns prior to entering a mutual fund, and therefore may have challenges determining if the fund is acting or behaving as intended.
  • The actual expenses of a mutual fund can be much more than advertised.
  • There is no way for an investor to customize her or his investments. All actions taken are made with the collective in-mind.
  • Other members of the fund could have financial objectives which largely conflict with those of the investor.
  • Misdirected or misguided decision-making by the fund manager.

All of these disadvantages are potential risks that any smart investor will want to manage or mitigate prior to entering a fund or portfolio.

Risks of Entering a Pre-Existing Portfolio

All investments come with a level of risk, and a mutual fund is no exception. In fact, mutual funds come with specific risks that an investor might not need to anticipate with an individual equity investment or alternative investment platform.

Poor Decisions Made by Fund Manager

One main reason some investors refuse to participate in funds of any type is that the investor is not the one making the decisions. Some investors not only prefer, but require, the control that comes with active investing.

A fund manager can become a liability, even if he or she is experienced and has a good track record of success. Like anyone else, a fund manager is human, and can make errors in judgement and compose a given fund poorly.

Moreover, in the case of a mutual fund, the fund manager is serving a number of different masters. A manager may be forced to sell a strong portion of the fund from a weak negotiating position because a member of the fund wants to take an early redemption.

Conflicting Financial Objectives

This rolls into the next risk of a mutual fund, which is that the financial objectives of an investor’s co-investors might not align with his or her own.

Using the example cited above, a fellow investor may want to sell shares of a given stock and exit the fund at an inopportune time. Regardless of the fund manager’s acumen, the manager may be forced to sell desirable shares at a relative-low in order to liquidate enough of the fund.

While many mutual fund investors are in it for the long game, some of the investors in any fund will be apt to pull out early. This is usually not the best way to maximize returns.

Early redemptions by fellow investors can devalue the fund by forcing the manager to sell valuable shares, and unfortunately, there’s really no way to mitigate this risk other than refusing to participate in a mutual fund.

Unwarranted Tax Liability

If an investor jumps into a mutual fund such as an index fund in a bull market, the investor may take on tax liability for the entire fund while only netting a fraction of the gains.

Smart investors will want to familiarize themselves with ways to reduce potential tax liability before entering a mutual fund, as well as understand the tax repercussions of early redemptions.

Like a merry-go-round, there is no perfect time to jump into a fund, but another way in which an investor can limit some tax liability to jump in while a fund is at a relative low. At least, this allows an investor to participate in the full profits of a given fund.

Inability to Customize or Harvest Constituent Equities

Lastly, individual portfolios and SMAs can “harvest” weaker stocks within the portfolio. While few investors will get rich with harvesting, in some cases, selling off weak stocks can offset operational expenses.

Because a mutual fund – especially an index mutual fund – is constructed in a particular way, an investor will not have the ability to customize the portfolio as he or she sees fit. This is something a potential investor needs to strongly consider prior to entering a mutual fund.

Is a Mutual Fund the Best Way to Invest?

Given all the places that a person can put their investment capital, a mutual fund serves as a very respectable, often smart choice for primary investment.

That said, whether a mutual fund is the right choice for a given individual is another question. Some investors, particularly those who value control and are willing to take on additional risk and greater fees, might see individual equity investment as the better way to invest.

Neither answer is wrong, but a potential investor will need to consider whether active or passive investing is a better pick for their personality type and disposition.


Linden Thomas and Company and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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