What is a Mutual Fund?
A mutual fund is a type of investment that pools funding from many individuals to invest in a wide range of securities, which may include stocks, bonds, and other assets. Mutual funds are a portfolio of investments managed by a portfolio manager that allocates the pooled funding to buy a selection of securities, as outlined in the fund's investment objectives in its prospectus.
Mutual funds are designed to give investors diversification without having to purchase individual securities themselves. Instead, investors purchase shares of the mutual fund, representing their ownership in the fund as well as the income it generates.
How Mutual Funds Work
Mutual funds are professionally-managed investment vehicles that give smaller investors access to a diversified portfolio of investments for a management fee. A mutual fund represents the investments of a mutual fund company, which issues shares that can be purchased. Investors purchase shares of a mutual fund at the net asset value per share (NAVPS) price, giving them a percentage of ownership in the fund.
The fund's performance is dependent on its underlying investments, which are typically made up of stocks, bonds, or a combination of securities outlined in the fund's prospectus. Fund managers typically have an investment objective for the fund, such as growth, or income, and will trade securities to align with those goals.
Mutual funds pay investors via dividends, capital gains, or equity growth of the underlying investments.
Types of Mutual Funds
There are many types of mutual funds on the market today, each of them containing a unique collection of assets for different investment goals. Most mutual funds fall into one of these four categories:
An equity fund is a mutual fund that is invested in stocks that fit certain characteristics. Equity funds may be classified in a few different ways:
Size. Some funds are designed for company market capitalization size, such as small-, mid-, or large-cap
Investment approach. Some funds are designed for investment goals, such as growth, income, or value-based investments.
Sectors. Some funds are designed to give investors diversification by investing in a variety of stocks within a certain sector, such as energy, technology, or financial
There are thousands of equity funds of every shape and size, giving investors the ability to create a diversified equity portfolio by selecting just a few of them. But keep in mind that equity funds rise and fall with the performance of individual companies and with the stock market.
Fixed-income mutual funds (also known as bond funds) are typically invested in bonds or other fixed-income securities to help investors preserve capital and provide predictable income from earned interest. Bonds and other debt instruments typically pay out a fixed interest rate or regular payments that help investors generate monthly or quarterly income in the form of distributions from the mutual fund.
Fixed-income funds are not without risk and can lose value. The risk of the underlying investments in a fixed-income fund depends on the fund manager's investing strategy, and investors should always understand how the fund plans to generate income before purchasing.
Balanced funds (also known as hybrid funds) are designed to invest in both stocks and bonds, as well as other securities to help investors reap the rewards of capital appreciation, while also holding income-producing assets within the fund. Many balanced funds invest in equity and fixed-income mutual funds themselves, giving greater exposure to a larger number of securities for its investors.
Money Market Funds
Money market funds are the "safest" mutual fund option, investing in low-risk debt securities, such as US treasury bonds or municipal bonds. These funds invest in high-quality, short-term investments with high liquidity. These funds do carry a risk of loss, and are not to be confused with money market accounts (which are not investments, but a type of savings account).
Example of a Mutual Fund
While there are many mutual funds on the market, one of the most popular mutual funds available is the Vanguard S&P 500 index fund (VFIAX). This fund owns the 507 total stocks represented in the S&P 500 index, while charging a very low expense ratio to investors. The percentage of each stock is market cap weighted (just like the index), meaning the greater the market cap of the company, the greater the percentage of the fund that company represents.
As companies are added or subtracted from the S&P 500 index, this fund will follow suit and purchase or sell shares to stay in line with the index.
Active vs Passive Mutual Funds
While all mutual funds are managed, not all of them are "actively" managed. An actively managed fund has a fund manager that buys and sells securities within the fund to reach the fund's investment objectives. Given this active nature, most active funds have higher management fees than their passive counterparts.
A passively managed fund typically has a preset investment strategy that favors holding a set of securities instead of actively trading to perform. The most popular passive funds are index funds that typically hold the same securities that are within a given index (such as the S&P 500). Since these funds are not actively managed, management fees tend to be much lower.
How to Invest in Mutual Funds
Investing in mutual funds is an easy way to diversify your holdings and reap the rewards of holding hundreds of securities without individually purchasing them. Here's how to get started investing in mutual funds:
1. Set Investing Goals
Before you decide to invest in a mutual fund, you need to determine why you are investing. Whether it's for short-term growth or investing long-term toward retirement, setting your investing goals will help you inform the type of investments you will choose.
2. Pick an Investment Firm
When you have a few goals to invest toward, you can start researching some of the top online brokers, with hundreds of mutual funds to choose from. Many traditional investment firms allow you to open accounts and invest online as well.
For example, Vanguard is one of the largest mutual fund companies in the U.S. and offers a variety of low-cost index funds as well as actively managed options for investors. Users can open an account online, transfer funds over, and choose which mutual fund they want to invest in.
Vanguard also offers its Personal Advisory Services to help manage your investments across several mutual funds to help you hit your investing goals.
4. Invest Regularly
Once you choose to purchase a mutual fund, one of the most powerful ways to grow your investment is to invest at regular intervals. Also known as dollar-cost-averaging, setting up a recurring investment (say, monthly) will help you invest small amounts over time, and take advantage of the power of compounding interest.
5. Rebalance as Needed
Once you are invested in mutual funds toward your goals, it's always wise to rebalance your portfolio on a regular schedule to stay within your preferred asset allocation.
This may mean buying or selling mutual funds to rebalance the percentage of your portfolio in a given asset class.
For example, if you want to be invested in 60% equities and 40% fixed-income, and your equities have grown and now represent 70% of your overall portfolio, you may need to sell 10% of your equities to purchase more fixed-income mutual funds. This will help you regain the 60/40 balance that you prefer in your investing portfolio.
Mutual Fund Fees
Mutual funds come with management fees (also known as expense ratios), but some also carry other fees as well. By and large, passively managed mutual funds have fewer (and lower) fees than their actively managed counterparts. Here are a few common fees that mutuals funds may charge:
Management fees. Cost to pay the fund managers of the mutual fund.
Sales loads. Commissions paid to brokers for selling the mutual fund. Also known as "front-loaded funds."
Account fees. Fees for maintaining your investment account (usually incurred when the account falls below a minimum threshold).
12b-1 fees. Marketing fees and other service fees incurred with selling the mutual fund.
There may be other fees involved with owning a mutual fund, and investors should always read through the prospectus for all of the details.
Pros and Cons of Mutual Funds
Mutual Funds can be a great way to quickly diversify your investment portfolio, but there are some drawbacks to know about as well.
Diversification. Mutual funds are designed to give exposure to hundreds, or even thousands of individual securities in a single investment, allowing instant diversification for investors.
Easy-to-Invest. Mutual funds are as simple to purchase as a stock, and can be bought or sold by investors with ease. With low-minimum investment requirements, mutual funds make owning a basket of stocks or bonds easy for beginner investors.
Professionally managed. Mutual funds are designed and managed by professional investors, taking the burden off individual investors to make investing decisions.
Fees. Sales commissions, annual management fees, account fees, and other charges may make mutual funds a costly investment choice.
Trade timing. While purchasing and selling individual securities allow for near-instant trade execution, mutual fund trades always capture the closing price of the market, which may not be the price you were expecting.
Mutual funds can be an excellent investment vehicle for helping investors get instant diversification across an asset class, while keeping minimums low for beginner investors. Actively-managed funds put professional investors to work on your behalf, while passively-managed funds give you a low-fee option to grow your holdings along with a given index or asset class.
Fees can crush your investment gains if you're not careful, so always review the mutual fund prospectus and understand all the fees and charges associated with investing in a given fund.