Many people see mutual funds as a great investment vehicle. Consider the advantage: Because they’re funds that contain a variety of assets, you get automatic diversification. If Company A’s stock crashes, you’d lose a lot if you were directly invested in it. But if it’s only a portion of the mutual fund in your portfolio, your risk exposure is considerably less.

That idea isn’t wrong, but it’s also not entirely right. As with many things in the world of personal finance, it takes some digging under the surface to see why.

Monolithic diversification?

Over-reliance on mutual funds can lead to something I call the duplication trap. To understand what that means, consider the common scenario of a portfolio invested in more than one mutual fund.

Generally, when choosing a mutual fund, you look for the ones that perform the best. If you invest in 15 of the top-performing mutual funds, the logical assumption is that you’re well-diversified: Each mutual fund is itself diversified because it owns multiple assets. If one of the mutual funds makes unfortunate investment decisions and performs poorly, because you’re diversified in mutual funds themselves, the other 14 can help buffer the losses.

Making that assumption, however, risks a fall into a duplication trap. Consider why those 15 funds are the top-performing funds. Odds are, it’s because they’re all investing in largely the same assets! For example, if Mutual Fund 1 invests in Microsoft ( MSFT ), Apple, Google ( GOOG ) and Nvidia ( NVDA ), and so do Mutual Funds 2 through 15, then what you’ve done is invest in the same four tech companies 15 times. Suddenly, all that diversification doesn’t seem so diverse.

This is why it’s important to investigate what exactly the mutual fund you’re considering is invested in, especially if you already have other mutual funds in your portfolio. There’s no point in getting a second mutual fund that virtually mirrors the first — you might as well just increase your position in the first fund.

Unanticipated fees

I recently worked with a client who had about $1.3 million invested in mutual funds. She’d been working with a large financial services firm that charged fees for their services. What she failed to understand is her fees didn’t stop there. Each mutual fund has an expense ratio — a fee you pay for the management of the fund, separate from your adviser. She was paying considerably more than she realized in fees to hold multiple mutual funds that were all largely duplicates of one another.

This is a common hazard when working with very large financial services firms. When a firm scales up its operations to accommodate millions of clients, it must streamline. It’s impossible to individualize advice for every client, so the firm usually puts each client into a risk-tolerance category and then chooses funds for that category rather than the individuals in it.

This generally leads to a lack of diversity in your investment options, which can lead to paying excessive fees while tumbling headlong into the duplication trap.

Uncontrollable income

Another weakness of a mutual fund-heavy portfolio is most funds pass on the earnings (capital gains) to the fund holder, you. Each year, the investor must pay capital gains taxes on the distribution, regardless of whether you wanted it or not. You might ask, who wouldn’t want someone handing them cash in exchange for having to pay taxes? However, taxes aren’t the only issues these distributions can cause.

The client I mentioned above retired early, well before she was eligible for Medicare. When you do that, you need to find a way to cover your health care until you become eligible. This can be very expensive unless you qualify for reduced-cost plans through the Affordable Care Act. To qualify, your income needs to remain under certain limits depending on your household size.

If you’re heavily invested in mutual funds, all of which are sending you money each year, you may not be able to keep your income under those limits. Dividends for people with sizable stakes can be in the tens of thousands of dollars, forcing you to pay very high insurance premiums until you become eligible for Medicare at age 65.

This is a good example of why it’s important, as you near retirement, to consider how your investments might impact your finances in unexpected ways. Will they force you to pay too much for health care? Will they move you into a higher tax bracket? You need to be in control of how your retirement money gets distributed to avoid unpleasant surprises in health care spending or tax season.

In general, mutual funds are a solid choice for younger-to-middle-age investors who don’t yet have a financial adviser, especially if they’re part of your employer-sponsored 401(k) where a company match is available. As you approach retirement and start shopping for a financial professional, it’s a good idea to consider whether you should continue that strategy. Work with your adviser to determine the best investment strategy for your unique situation as you approach and enter retirement.