Mutual funds are an investment vehicle with the capability to pool money from multiple investors to purchase a diversified collection of stocks, bonds and other assets. In recent years, mutual funds have often been misunderstood and, at times, overshadowed by the dominant likes of exchange-traded funds (ETFs). However, they offer their own unique advantages and features, making them a reliable, innovative and longstanding investment vehicle option.

How do mutual funds work?

Mutual funds operate under one of the most robust regulatory regimes in global finance, the Investment Company Act (ICA) of 1940 (also known as the ’40 Act). This act enforces strict portfolio diversification rules, transparent reporting, limits on leverage, and clear fiduciary duties – meaning investors know exactly how the fund must be run. And, mutual funds strike a net asset value (NAV) once per day, providing predictable execution and eliminating intraday trading frictions. For long-term investors, this can smooth out noise and reduces the temptation to trade impulsively.

NAV pricing also eliminates the bid-ask spread, which can add up from a frequent rebalancing or tactical trading perspective. Generally, there are zero commissions associated with mutual funds, while ETFs may have an execution commission depending upon the broker. Mutual funds also provide active oversight and fiduciary management, since portfolio managers, analysts and compliance teams continuously monitor holdings behind the scenes. This professional oversight helps ensure discipline, alignment with stated mandates and overall risk management.

What are the advantages of mutual funds?

Even as ETFs dominate flows, mutual funds have structural advantages in several important areas to consider, such as:

  • Automatic investing and automatic rebalancing
    • Mutual funds are tailor-made for paycheck-driven contributions, like 401(k)s, 403(b)s and 529 plans. Many individual retirement accounts (IRAs) rely almost entirely on mutual funds for seamless automation. Until there is wide adoption of fractional shares, mutual funds will remain the only game in town for periodic investment.
  • Target-date funds and retirement qualified plans
    • Target-date funds have now become the most common default investment in U.S. retirement plans and they are classified as mutual funds. Their embedded glide paths and rebalancing mechanics fit the mutual fund structure exceptionally well and set them apart.
  • Not all asset classes are ETF-friendly
    • Strategies where active trading is a large portion of the value proposition, which includes many alternative strategies such as relative value, arbitrage and derivatives, are better accessed by a pooled vehicle like a mutual fund. Additionally, using an ETF almost always means choosing the most highly liquid bonds, which could have negative selection bias since most liquid bonds almost always have the largest issuance.
  • Reduced impact from intraday trading pressure
    • Since mutual funds only transact at the end of the day with NAV, managers don’t have to contend with intraday flows, arbitrage pressures or hedge funds exploiting moment-to-moment movements.
  • Institutional asset management
    • Due to mutual funds ability to access institutional-level management, cases arise when investors may be able to build a separately managed account accessing lower cost structures than an ETF’s.
  • Lowered chance of impulse trades
    • Since you can’t trade during the day, mutual funds remove behavioral pitfalls. Sometimes mutual funds’ best feature is the inability to make an impulsive trade at 1:23 a.m.

Mutual fund misconceptions

There are several misconceptions swirling around mutual funds that have caused them to be overshadowed. Mutual funds haven’t lost relevance; they’ve simply lost attention. So, as you explore if a mutual fund is right for you, be sure to keep the below misconceptions in mind.

  • Limited structural control
    • Mutual funds have the ability to institute a soft or hard close as the strategy becomes constrained by capacity to deploy marginal assets. For example, small and micro-cap strategies may move markets or become illiquid if they become too large.
  • “ETFs are always cheaper”
    • This isn’t universally true. Many index mutual funds have expense ratios competitive with ETFs and institutional share classes can actually be cheaper than corresponding ETFs.
  • “ETFs outperform mutual funds”
    • Investors sometimes assume ETFs outperform because of trading flexibility or tax efficiency. But in many active categories, such as municipal bond funds, active credit, and international equity, mutual fund performance has remained strong when relative to passive alternatives.
  • Newer equals better
    • ETFs are the newer, more modern-feeling product. The industry’s innovation narrative skews publicity toward ETFs, even when mutual funds remain the more functional tool for many investors.
  • Tax-efficiency misunderstandings
    • ETFs typically offer greater tax efficiency, but this matters primarily in taxable accounts. Most mutual fund assets sit in tax-advantaged retirement plans where ETF advantages disappear.

The role mutual funds play in a diversified portfolio

Mutual funds still play a foundational role in modern portfolio construction. For 401(k), 403(b) and IRA investors, mutual funds (especially target-date funds, core bond funds and diversified equity funds) often remain the best all-in-one solution. Mutual funds excel in “set it and forget it” contexts where investors want automatic deployment of savings, automatic rebalancing and professionally managed frameworks – making them the best tool for systemic investing. Also, for investors seeking active management in areas where research skill matters (i.e., municipals, emerging markets, small-cap value, active credit) mutual funds often provide a clean exposure option.

Additionally, mutual funds are a great complement to ETFs in a portfolio. While ETFs handle tactical exposures, intraday trading and tax-efficient rotation, mutual funds handle disciplined accumulation and professionally managed allocations. An optimal portfolio will use ETFs for precision allocation and tax-efficient satellites and mutual funds for long-term core holdings and automated retirement planning.

With trillions in retirement accounts, constant automatic contributions and the dominance of target-date funds, mutual funds remain a structural backbone of American investing. If you’re interested in setting up a mutual fund or simply learning more about how one could benefit your unique financial picture, be sure to speak with your trusted financial ally – they can provide accurate, personalized guidance and next steps.

Jacob Omer, senior investment analyst at UMB Bank, also contributed his insights to this blog.

Learn more about UMB Fund Services and how we can support your firm’s registered and alternative investment fund administration needs, or contact us to be connected with a fund services team member.