5 Mutual Fund and ETF Red Flags

The universe of mutual funds and exchange-traded funds continues to grow. Here are some common pitfalls investors should be aware of.

It may seem harsh, but investors need to look out for themselves.

Mutual funds and exchange-traded funds, or ETFs, are both investment products, and every investment category may contain a few lemons. Some can quietly drain your returns or create complications that only become obvious after you've already invested.

The issue isn't always tied to performance. Sometimes, lackluster returns come down to timing or the broader market conditions affecting the assets inside the fund. What matters more are structural deficiencies that may not be evident without doing your full due diligence.

For mutual funds and ETFs, a red flag is any feature or trait that meaningfully drags on long-term results or introduces unnecessary complexity, friction or risk to the investor. Recognizing these problems before investing can help you avoid funds that are more trouble than they're worth.

Here are five mutual fund and ETF red flags prospective investors should look out for:

Low assets under management (AUM).

Capital gains distributions.

Excessive fee structures.

Wide bid-ask spreads.

Closet indexing.

Low Assets Under Management (AUM)

A new ETF launching with smaller AUM isn't necessarily cause for concern. Aside from initial seed capital, which is typically provided by the fund sponsor or a partner to get the ETF trading, it takes time for investors to notice a new fund and for meaningful inflows to arrive.

But context matters. If an ETF has been on the market for some time and still has a low AUM, that's a potential red flag. According to ETF.com, surpassing $50 million in AUM is the rule of thumb where the risk of ETF closure becomes less of a concern.

That's because ETFs are businesses. They generate revenue by charging an expense ratio, which is a percentage of AUM. When an ETF has too little AUM, the amount of revenue it earns might not cover the costs of running the fund. In other words, the fund may not be financially viable.

For investors, this doesn't usually mean losing money. If an ETF shuts down, you'll get paid the net asset value (NAV) of your shares in cash. But it's still a hassle. If your investment had a paper gain, it now becomes a realized capital gain that may be taxable. And you'll need to go out and find a new ETF to replace the one that closed.

It may seem harsh, but investors need to look out for themselves. If an ETF has been around for a while and remains stuck below $50 million in AUM, it might not be long for this world.

Capital Gains Distributions

Unlike ETFs, mutual funds don't trade on a secondary market. When you buy or sell a mutual fund, you're transacting directly with the fund itself. As a result, the actions of other investors can have real consequences, especially when large groups sell at once.

"While this is not a new concept, a fund with stellar historical performance and subsequent underperformance is typically a victim of high embedded capital gains," says Mark Andraos, partner and wealth advisor at Regency Wealth Management.

This happens when early investors benefit from strong gains that remain unrealized within the fund. If the fund later underperforms and experiences a wave of redemptions, the manager may be forced to sell those appreciated holdings to raise cash. That triggers taxable capital gains, which are then distributed to all shareholders, including new investors who didn't benefit from the earlier gains.

"Strong historical performance plus significant recent outflows is usually a recipe for a hefty tax liability," Andraos explains. "If you buy into a mutual fund that fits this profile, you're potentially paying taxes tomorrow for someone's gains yesterday."

In practical terms, you could invest in a struggling mutual fund in early December and wind up receiving a surprise capital gains distribution weeks later, despite not having participated in any of the fund's prior growth. Worse still, mutual fund investors can get punished during market downturns if other shareholders panic.

"Former Fidelity Magellan Fund portfolio manager Peter Lynch wrote about this years ago," says David James, managing director at Coastal Bridge Advisors. "During a major market crash, many investors panicked and sold Magellan shares at or near the bottom, which forced the manager to sell securities at the lows to raise liquidity to meet the redemptions."

This not only locked in losses for the fund but also triggered tax events for everyone still holding it. "Even if you personally saw the decline as an opportunity, you were saddled with your pro rata share of the loss here," James explains. "This wouldn't have been true if you owned the securities directly and simply held through the volatility."

Excessive Fee Structures

Due in part to the "Vanguard effect," a term used to describe the downward pressure on investment costs sparked by Vanguard's low-cost index fund model, fees across both mutual funds and ETFs have steadily declined over the past two decades.

But not all managers have followed suit. Despite the industry-wide trend toward affordability, a number of holdout mutual funds continue to charge steep fees, often due to inertia, complacency or lack of investor awareness.

This is especially egregious when two funds offer identical exposure but with dramatically different costs. For instance, you can gain S&P 500 exposure through the Fidelity 500 Index Fund (ticker: FXAIX), which charges a razor-thin 0.015% expense ratio.

Or you could end up in Guggenheim Investments' Rydex S&P 500 Class A (RYSOX), which tracks the same index but charges a 1.62% expense ratio. On a $10,000 investment, that's a $160 annual difference for the same U.S. large-cap stock exposure. Over a long holding period, this can compound into serious underperformance.

"A big red flag for me is a high expense ratio, especially if it's a passive fund," says Anessa Custovic, chief investment officer at Cardinal Retirement Planning Inc. "If you have a mutual fund that simply tracks the S&P 500 or really any well-known index, they shouldn't have a high expense ratio."

But the fee story doesn't end at the expense ratio. Some mutual funds still charge 12b-1 fees, which are annual marketing or distribution fees taken from fund assets. These are often poorly disclosed, and while the Securities and Exchange Commission has fined firms for misleading investors about them, they are still legal.

Finally, some mutual funds continue to levy sales charges, also known as loads. A front-end load deducts a percentage of your investment at the time of purchase, while a back-end load takes a cut when you sell. These fees do nothing to improve fund performance and are increasingly seen as outdated, especially with the rise of no-load funds.

"Average equity fund expenses slid to 0.4% in 2024, and 92% of new flows went to no-load share classes, so paying north of that plus a 12b-1 marketing surcharge is like paying extra to watch ads on Netflix," says Michael Ashley Schulman, chief investment officer at Running Point Capital Partners. "High costs are the one red flag that, on average, reliably predicts lower future alpha."

Wide Bid-Ask Spreads

ETFs trade on exchanges just like individual stocks and have two prices: the bid, which is the highest price a buyer is willing to pay, and the ask, which is the lowest price a seller is willing to accept.

The difference between the two is called the bid-ask spread, and it represents the implicit cost of trading the ETF, with narrower spreads being better. These are often reported as a 30-day median to smooth out daily fluctuations.

For instance, a very liquid ETF like the iShares Core S&P 500 ETF (IVV) has a minuscule 0.01% 30-day median spread. It might seem logical to assume that an ETF's trading volume determines its spread, but the real driver is the liquidity of the underlying assets.

In the case of IVV, the fund holds stocks in the S&P 500, some of the most heavily traded equities in the world. That makes it easy for market makers to price the ETF tightly and offer narrow spreads.

Contrast that with a fund like the Global X MSCI Argentina ETF (ARGT), which has a much wider 0.24% median spread. The underlying Argentine equities are less frequently traded, can be harder to price in real time and often have their own wide local spreads, which get passed through to the ETF level.

For investors using ETFs as trading tools or making frequent buys and sells, these spreads are costs that can add up. Even if an ETF has a low expense ratio, a wide bid-ask spread can quietly eat into your returns. Always factor it into your total cost of ownership.

"I would also be very suspicious of ETFs with high bid-ask spreads," Custovic says. "This to me signals low liquidity, potentially high transaction costs or even lack of buyers in the market."

Closet Indexing

One final red flag investors should watch for is closet indexing, a phenomenon where an actively managed mutual fund or ETF claims to try and beat the market, but in reality, holds a portfolio that closely mirrors its benchmark.

Unlike index funds, which simply license and replicate a benchmark like the S&P 500, active funds usually come with higher fees because they employ portfolio managers and research teams tasked with selecting stocks that they believe will outperform an index.

But if a fund's holdings are nearly identical to the benchmark, there's little chance it will outperform, especially after subtracting those higher management fees. In effect, you're paying for what amounts to an index with some slight tweaks, but at a much higher cost.

The fund industry uses a metric called active share to measure how different a fund's holdings are from its benchmark. Active share ranges from 0% to 100%, where 0% means the fund owns exactly the same stocks in the same proportions as the index, and 100% means no overlap at all.

While there's no official cutoff, funds with an active share below 50% are often accused of closet indexing, because the overlap is too high to justify active fees. Many funds fall into this trap.

For example, the popular Fidelity Blue Chip Growth Fund (FBGRX) has an active share of just 37.3%, according to Morningstar, despite charging a 0.47% expense ratio. For that price, investors might reasonably expect more differentiated stock selection.

Closet indexing often exists because of career risk. By hugging the benchmark, active fund managers limit how far their results can stray from it, reducing the chance of major short-term underperformance that might get them fired.

This tendency to prioritize job security over bold decision-making can lead to portfolios that are indistinguishable from passive strategies, despite being actively managed and priced as such.