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The primary advantages of mutual funds are summed up in an oft-heard litany: diversification, professional management and convenience. By and large, most funds do achieve this basic mission. Over and above that, funds offer lower costs by virtue of their size; they may receive breaks on trading costs, and they certainly spread many internal costs over a large shareholder base, allowing for economies of scale. On the negative side, funds make tax planning difficult (because the timing of taxable distributions is uncertain), and may be somewhat difficult to track in terms of what they actually are investing in (which is generally not disclosed until after the fact for competitive reasons). In addition, so-called non-substantial changes in the way the funds are managed (such as manager switches) may not be disclosed to investors by fund companies in a timely manner.

How it Works. Diversification is a tremendous benefit of mutual funds. For a low minimum investment, in most cases, an investor can own hundreds or thousands of individual security issues through a single fund, and thus spread risk over a substantially broader base. Taking things one step further, different types of funds allow participation in many types of securities, such as foreign stocks, foreign bonds, real estate securities, technology stocks, small companies, and so on. Thus, a single investor can assemble a portfolio of mutual funds that invest in different asset classes. The chance of any single person being sufficiently well-versed to manage such diverse investments is highly unlikely, even if done full-time! In the extreme, funds may even own other mutual funds, resulting in a virtual all-in-one portfolio. An example of the all-in-one, "fund of funds" approach would be Vanguard's Star Fund. The Star Fund invests in about eight other Vanguard funds with different objectives -- small stock, blue chip stock, bonds, etc. -- with no additional expenses added onto the low expenses of the underlying funds. Such a fund might serve as an entire investment portfolio for the small investor.

The second potential benefit, professional management, is always guaranteed, but sadly, only because managers of funds are paid for their services. Fortunately, truly dismal mutual fund management is rare (I can think of only a handful of cases where investment returns have badly trailed the relevant market measures over substantial periods of time). Finally, there is no doubt that investors benefit from substantial convenience by investing in mutual funds. They are relieved of the day-to-day tasks involved in researching, buying and selling securities. In the case of individual securities, day-to-day vigilance is a virtual requirement, especially in a diversified portfolio, with many holdings. Mutual funds, on the other hand, need not be looked at on a daily, weekly or even monthly basis. Occasional reviews, perhaps once a year, will suffice. (Helpful Hint: the same guidelines and practices for picking a mutual fund in the first place are also useful for fund reviews.)

Perhaps the biggest negative aspect of mutual funds is tax-planning difficulty and uncertainty. Funds make taxable distributions in a largely hard-to-foresee manner. In addition, they are required to distribute long-term capital gains in the year realized; thus the investor loses control over the timing of the realization and taxation of capital gains, contrary to the situation where an investor who owns securities outright, can choose sale dates.