Millions of Americans use mutual funds to help meet their investment and retirement goals, but you may not know exactly what they are or how to start investing in them. Like many financial products, they can be intimidating at first, but mutual funds are fairly simple to understand with a little help.
What is a mutual fund?
A mutual fund is a pool of money collected from investors that is then invested in securities such as stocks or bonds. Each share in the fund represents a proportional interest in the fund’s portfolio, so the more shares you own, the larger your interest in the fund.
If a fund holds 5 percent of its portfolio in Apple and 2 percent in Tesla, for example, your share of the fund will hold the same stocks in the same proportions.
There are thousands of mutual funds that allow you to invest in a variety of ways. You can find funds that invest in a diversified group of large companies, small companies, specific geographies or even certain sectors of the economy.
Who should invest in a mutual fund?
Mutual funds can make sense for many investors at different points in their investing lives. But it’s important to remember that it’s not about the mutual fund itself, but rather what goes into the mutual fund that will determine whether the investment makes sense for you.
These funds can hold assets like bonds, stocks, commodities or a combination of several asset classes. You’ll want to do your research before investing in a fund and make sure you understand the risk of the fund’s underlying assets.
Mutual funds are good options for both beginners and more experienced investors alike. Both types of investors will benefit from the diversification of mutual funds, and experienced investors can find funds that target specific areas they think are poised for growth.
Active vs. passive mutual funds
One of the biggest distinctions between different mutual funds is whether they pursue an active or passive investment strategy. The difference will determine how the fund invests and can ultimately have a big impact on the returns you earn as an investor.
Active mutual funds
Active funds are managed by professional investors with the goal of outperforming a market index, such as the S&P 500 index. For an active stock fund, the fund manager and a team of analysts will work to identify which stocks to own and in what quantities to achieve the best returns. Similarly, active bond funds will attempt to beat bond indices through superior management.
But it’s not as easy as it sounds, and actively managed funds often fail to match the performance of the index they’re trying to beat in the first place. On top of that, active funds come with larger fees (often around 1 percent of the fund’s assets) to pay for professional management, so the returns to investors are lowered further through these types of costs.
Passive mutual funds
Passive mutual funds are managed to track the performance of a market index. They do not require an expensive investment team to manage the portfolio because they aren’t trying to identify the best performers, they’re just trying to match the index. This allows passive funds to charge very low fees and sometimes no fees at all, which leaves more of the return for the fund’s investors.
Passive funds may sound simple and even a little boring, but they have consistently beaten actively managed funds over long time periods. There will always be a few active funds that outperform their benchmark over short time periods, but very few will do so consistently over the long term.
Types of mutual funds
There are many different mutual funds available and it can be confusing to navigate them all. Let’s take a look at some of the more popular types of funds.
- Stock funds
- These funds invest in corporate stocks, but can also pursue different strategies from fund to fund. Some funds focus on companies that pay dividends and are well established, while others are more focused on growth and the potential for price appreciation. Still, others are focused on specific industries, sectors, or geographies.
- Bond funds
- These funds invest in various forms of debt and their risk profiles can vary widely from fund to fund. Some will invest in relatively safe bonds issued by governments, while others invest in so-called “junk” bonds that offer higher potential returns. Be sure to read the prospectus before investing to make sure you understand the risks being taken.
- Money market funds
- These funds tend to be low-risk and earn a small return above that of a normal savings account. Money market funds invest in high-quality short-term debt issued by companies and governments.
- Index funds
- These funds have surged in popularity in recent years due to their simplicity and low-cost structure. Index funds track the performance of an index such as the S&P 500 and are usually able to keep costs low. Studies have shown this passive approach outperforms active management over long time periods in most cases.
How do mutual funds make you money?
Mutual funds make money by investing in securities on your behalf. The fund can only do as well as the underlying securities it holds. Income and appreciation are generally the two ways you can make money in securities.
Income comes in the form of interest or dividend payments that are then passed on to you as a fund investor. Appreciation can be reflected in the net asset value per share of the fund or distributed to investors in the form of capital gains, minus any losses.
How to choose a mutual fund
Choosing which fund to invest in can be intimidating when you look at all the different options. The first thing to consider is whether a fund’s investment objectives are aligned with your long-term financial plan. For beginning investors who are early in their careers, investing in a low-cost S&P 500 index fund is likely to be an attractive option.
For more experienced investors or for people looking to invest in an actively managed fund, more research may be required. You’ll want to understand a fund’s overall approach and investing philosophy and who the portfolio managers are that will be making investment decisions on your behalf.
Ultimately, a fund’s performance is what will matter to you as an investor, so try to understand the drivers of a fund’s long-term performance and whether that is likely to continue in the future.
You’ll also want to consider the fees associated with purchasing shares in a fund. Remember that if two funds have the same investment performance, the one with the lower fees will leave their investors better off.
How to buy mutual funds
Mutual funds can be purchased through online brokers or through the fund manager themselves. But there are some differences between the way mutual funds trade and the way a stock or ETF trades.
- Pricing: Mutual funds are priced at the end of each trading day based on their net asset value, or NAV. The NAV is calculated by adding up the value of the fund’s holdings, subtracting expenses and dividing by the number of shares outstanding. When making a purchase, you’ll receive the next NAV, so if you place an order after the market has closed, you will receive the next day’s closing NAV as your price.
- Minimum investment: Most mutual funds have a minimum investment of a few thousand dollars and you can choose to buy a certain dollar amount of a fund or a specific number of shares.
How to sell mutual funds
Mutual funds are sold similarly to the way they’re bought. Using an online broker or the fund’s manager, you’ll place a sell order and will receive the next available NAV as your price. Since mutual funds don’t trade throughout the day like stocks or ETFs, you won’t know the price you’re selling at until the trade goes through.
Mutual funds sometimes have fees for selling the fund in a short period of time, known as early redemption fees, and are therefore not ideal for short-term trading. They’re best used as vehicles for long-term investment and are commonly held in retirement accounts or invested towards another long-term goal. You don’t need to monitor the fund’s performance daily or even weekly when you’re invested for the long run. Checking in quarterly or a couple of times each year should be enough to make sure the fund is still aligned with your objectives.
Why should you invest in a mutual fund?
You should consider investing in a mutual fund if the fund’s objective matches your investment needs. A fund that invests primarily in stocks isn’t going to be suitable if you think you’ll need the money one year from now, while a bond fund likely won’t be the best option if you’re looking for a fund to help meet long-term retirement goals in the distant future.
Make sure to read a fund’s prospectus before investing to understand how your money will be invested and whether it makes sense for your own financial goals.
Watch out for mutual fund fees
One of the most important things to be aware of when investing in mutual funds is the fee you’ll be paying. You can find this information in the fund’s prospectus, and while it may not sound like much, costs really add up over time.
Funds can charge fees for a number of costs that relate to the operating expenses of the fund. Management fees pay for the fund’s managers and investment advisor, while 12b-1 fees cover the costs of marketing and selling the fund. Other expenses include legal, accounting and a variety of administrative costs.
You may also come across what are known as load and no-load funds. Loads, or commissions, are charged by some funds and paid to brokers at the time of purchase or sale of shares in the fund. The commissions are typically calculated as a percentage of your overall investment. Funds that don’t charge this commission are known as no-load funds.
Just a 1 percent annual fee can significantly eat into your return over a decades-long investing life and throw a wrench into your retirement plans. While no one knows how well an investment might perform, everyone can be certain how much they’ll pay in fees. In many cases, you can buy the same kind of fund, such as an S&P 500 index fund, with much lower expenses.
How are mutual funds taxed?
Taxes might also be considered fees that eat into the ultimate return you earn as an investor. If you own mutual funds in a taxable account such as a brokerage account, you’ll owe capital gains tax if the fund has appreciated from where you bought it at the time of sale. One way around this is to own the funds in tax-advantaged accounts such as a traditional or Roth IRA. In those accounts, your funds will be allowed to grow tax-free even if you sell them. You’ll eventually pay taxes on withdrawals from a traditional IRA, but Roth IRA withdrawals are tax-free during retirement.
Mutual funds vs. ETFs: How they differ
Mutual funds and ETFs have a lot in common, but there are some key differences. Here are the main ones to consider.
- Minimum investments: Mutual funds typically come with a minimum investment of a few thousand dollars, while ETFs usually have no investment minimum.
- Trading: ETFs trade throughout the day on exchanges similar to the way that stocks trade, while mutual funds can only be bought and sold once a day at their closing NAV.
- Expense ratios: While it will depend on the type of fund you’re investing in, expense ratios tend to be lower for ETFs than for mutual funds. However, a mutual fund that tracks an index such as the S&P 500 will be cheaper than an ETF that tracks a very narrow industry or geography.
- Fees: ETFs typically have no fees beyond the fund’s expense ratios, while mutual funds sometimes have sales commissions that are charged during the purchase or sale of the fund. Be sure to understand all of the fund’s fees before investing.
Remember that a mutual fund or ETF isn’t itself the investment, but rather they’re the vehicles that allow you to invest in stocks, bonds or other securities. A fund can only be as good as the investments it holds, so be sure to understand how a mutual fund or ETF is invested before making a purchase.
Bottom line
Mutual funds can be a great way to invest in a diversified portfolio of securities for a relatively small minimum investment. Be sure to read a fund’s prospectus before investing and understand the risks involved. Consider investing in index funds as a way to help keep your costs low so that more of the return ends up in your pocket.
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