What Are Mutual Funds?
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Mutual funds are a simple way for investors to buy a group of securities with one purchase. These securities can consist of stocks, money market instruments, bonds, and other assets.
What You Should Know:
- Mutual funds are divided into different categories -- like Money Market Funds and Index Funds -- to help investors identify where their money will be best served.
- A fund’s annual operating fees, typically up to 1%, can put a dent in an investor's returns. Take note of all fees associated with a mutual fund before investing.
- With mutual funds, individuals can invest in a diversified portfolio, with most mutual funds holding over 100 securities.
- If you have a 401(k) or company-sponsored retirement plan, you may already be investing in mutual funds. According to the Investment Company Institute (ICI), over 60% of 401(k) assets are held in mutual funds.
How Mutual Funds Work
Mutual funds allow investors to pool their money in order to diversify their portfolios. Through diversification, both gains and losses are split among investors.
When an investor buys into a mutual fund, they purchase a share that represents a portion of the value of the fund’s portfolio.
Mutual Fund Managers
Mutual fund managers oversee the mutual fund portfolio and aim to pick winning stocks.
“A mutual fund manager is somebody who picks the stock. They essentially make the fund,” says Howard Dvorkin, author, and personal finance expert.
“If they're a good manager, the fund is going to perform well. If they’re a bad manager, investments will suffer.”
Mutual fund managers administer the fund according to a prospectus.
The mutual fund prospectus details the objectives of the fund and its investments, fees, and risks to provide an overview of the costs of investing in that fund.
Fund managers are divided into two groups: active and passive.
Active fund managers compete with other managers by taking on a more hands-on role to generate higher returns.
This includes researching companies, studying corporate balance sheets, reviewing sales, and keeping a close eye on economic and stock market trends.
Conversely, passive fund managers deal with investments within an index, so their returns must mirror those of the index fund they use as a benchmark.
Mutual Funds and Net Asset Value (NAV)
The price of a mutual fund share is determined by the net asset value (NAV). The NAV is the market value of a single mutual fund share.
The NAV is also representative of the fund’s closing price, which is determined at the close of the market and does not fluctuate during trading hours.
To better understand mutual funds, here are some key terms:
Held in a fund's portfolio are stocks and bonds that generate payouts called dividends. A fund pays out the income it has generated to its stockholders in the form of a distribution.
Furthermore, if a fund sells securities and other assets that have increased in price, this represents a capital gain that may also be paid out to stockholders.
Types of Mutual Funds
When it comes to mutual funds, there is no shortage of options for investors to pick from, so the choice can be somewhat overwhelming at first.
A good place to start is by assessing the amount of risk you’re willing to undertake, as well as your financial goals.
That said, the following are some of the main types of mutual funds available today:
- Money market funds. Invest in cash equivalents with low risk.
- Equity funds. Invest predominantly in stocks. More risk may result in higher returns.
- Bond funds. Invest in fixed-income issues such as corporate and government debt. These are not immune to market volatility.
- International funds. Focused on assets outside the United States to provide portfolio diversity. Some foreign economies may grow faster than the U.S., providing balance in the event of a recession.
- Balanced funds. Also known as asset allocation fund. Offers a mix of asset classes including stocks and bonds. This strategy aims to reduce risk.
- Value funds. Stocks that have a low price-to-earnings ratio. As such, investing in them is seen as a good deal and expected to pay dividends.
- Stock funds. There are several types of stock funds, but they all invest in corporate stock.
- Growth funds. Invest in companies that are expected to make above-average future earnings.
- Index funds. Run by passive fund managers. These funds mirror major market indices such as the S&P 500 and the Dow Jones Industrial Average.
- Income funds. Invest in stocks that pay dividends regularly.
- Target date funds. Also known as lifecycle funds, these are intended for those investing with a specific retirement date in mind. Asset allocation changes over time, becoming less aggressive and more conservative as the projected retirement date approaches.
Mutual Funds: Pros and Cons
There are many advantages to investing in a mutual fund. For starters, mutual funds offer enough variety to suit every kind of investor.
“On a basic level, there's a wide array of mutual funds,” says Daniel Czulno, CFP, co-host of the DIY Money podcast. “So, with mutual funds, you can run the gamut of a very simple investment strategy to a very complex one."
Another benefit of mutual funds is that they offer low-cost portfolio management, making them a convenient option for investors who don't want to decide which stocks to invest in.
Diversification of assets is another great selling point, as it reduces risk. However, that doesn't mean mutual funds are completely without risk.
“All investments carry risk,” says Gerri Walsh, Senior Vice President of Investor Education at the Financial Industry Regulatory Authority (FINRA). “[That’s why] it's important to recognize that while mutual funds are one way to diversify your assets, there are risks associated with them and they can vary from fund to fund.”
Finally, while mutual funds represent good opportunities for small investors, knowing when to invest is also key.
“People should be very cautious when they buy a mutual fund because most of them distribute capital gains at the end of the year,” says Dvorkin. “As a result, the last 45 days of the year are not the time to invest in mutual funds.”
Fees And Taxes
Investing in mutual funds involves a variety of fees that may vary depending on the fund. These fees typically range between 0.1% and 2%.
Some of these are management fees, annual fees, marketing and distribution fees (also known as 12b-1 fees), shareholder fees that include sales charges and commissions, and transaction fees which are applied when buying or selling shares.
“Any mutual fund that charges you a 12b-1 charge, you should always avoid like the plague,” says Dvorkin. “Over time, the difference between 1% and 1.25% will add up, and it will defer your game and negatively impact your returns.”
As required by the Securities and Exchange Commission (SEC), all mutual fund fees must be identified in a standardized table on the fund’s prospectus.
“Fees are something that every investor has to understand and look at when they are purchasing any type of investment,” says Czulno, “whether that is a mutual fund or they're just utilizing the services of a financial planner or investment advisor.”
Taxing the returns from your mutual funds happens in a couple of ways. When you buy and then sell a mutual fund, the difference is taxed as capital gains. Every year when a fund pays out profits, they are taxed as either dividends or capital gains.
Now, if you invest in a bond fund that includes interest-paying securities, those will be taxed at regular income tax rates.
How To Buy Mutual Funds
You can invest in mutual funds through your employer-sponsored 401(k) plan or even through an Individual Retirement Account (IRA).
Before buying mutual funds, decide whether you want to invest in a passive or an active fund. This usually depends on the investment strategy you want to follow, your risk tolerance, and your investment objectives.
Next, find a fund that fits your budget and do your research to understand all fees associated with the fund before making any commitments.
A useful tool to help you compare mutual funds, money market funds, and exchange-traded funds and notes is FINRA's Fund Analyzer.
You might also want to manage your expectations in terms of how much returns your fund will generate in the short-term. After all, investing is a long-term game.
“When investing, you should always be playing the long game,” says Czulno. “You shouldn't be putting money into risk assets that you need in less than five years, because investing by nature is a long-term vehicle for wealth creation.”
If you're going to put your investments in the hands of a professional, do your homework to make sure the person you're doing business with is licensed to sell securities or offer investment advice.
“With investment professionals, it's a really good idea to check them out on BrokerCheck,” says Walsh. "If they're not in there, that can be an important red flag.”
FAQs About Mutual Funds
What is the difference between a mutual fund and an ETF?
Exchange-traded funds (ETFs) and mutual funds have some key similarities and differences. Like mutual funds, ETFs invest in a mix of assets that help investors diversify their portfolios.
Unlike mutual funds, ETFs can be traded like stocks and are passively managed, so they're based on the performance of an index. Because mutual funds are actively managed, they have higher expense ratios than ETFs.
What do mutual funds invest in?
Mutual funds invest in stocks, money market instruments, bonds, and other assets based on the fund's investment objective.
What’s the main difference between investing in mutual funds and investing in the stock market?
Mutual funds invest in a variety of assets, whereas stocks are investments in one company. This allows investors to put their money into a diversified investment portfolio that carries less risk, instead of investing in individual stocks.
What are 12b-1 fees?
Expenses that are known as 12b-1 fees represent operational costs. These may include the cost of broker compensation and marketing efforts and are included as part of the mutual fund’s expense ratio. The 12b-1 fees cannot exceed 0.75% of the fund assets, as per rules set forth by the SEC.
Can you lose money in a mutual fund?
As with any other type of investment vehicle, you can lose some or all of the money you invest in mutual funds. Securities held in a mutual fund portfolio can lose value depending on market conditions, and dividends and interest payments may be affected as a result.