When you’re starting to invest, one of the first things you should know is the mutual fund definition: In short, mutual funds are a collective pool of investment funds. Buying mutual funds might be a good way to diversify your portfolio.
Thousands of different mutual funds are available that invest a wide variety of stocks, bonds and other securities. How to invest in mutual funds involves analyzing different factors, including your investment objective, risk parameters and cost. Here’s a look at the different types of mutual funds and how they work — if this type of investment is right for you, choose the best mutual funds for your portfolio today.
Mutual Funds Definition
By definition, mutual funds are a collective pool of investment funds run by a professional money manager that gives investors shares to represent their ownership interest. Three main types of mutual funds exist. Although all three share characteristics, they all feature slightly different structures.
Here are the three types of mutual funds you can invest in:
1. Open-End Mutual Funds
A “traditional” fund that you buy directly from mutual fund companies, open-end funds are continuously offered, meaning you can buy or sell them any day that the market is open. They’re priced based on their net asset values, or the value per share of their underlying assets.
2. Closed-End Mutual Funds
Closed-end mutual funds are like regular stocks in that they trade on the stock exchanges. They feature actively managed portfolios, just like open-end funds, but they aren’t continuously offered — you buy and sell them on the open market at the current market price.
3. Exchange-Traded Mutual Funds
An ETF is similar to a closed-end mutual fund in that it trades on the exchanges like a stock. Many ETFs, however, are passively managed and tend to mirror major market indexes like the S&P 500. Unlike closed-end funds, ETFs issue new shares on a regular basis, a process that helps keep the share price very close to the underlying net asset value, like an open-end fund.
As for how mutual funds work, you can make money by selling your mutual fund shares when the price has gone above the price you paid for them. Another way to make money with mutual funds is through income. If a fund earns any dividends or interest payments from the investments it holds, you receive those payments. Funds that pay dividends can pay them monthly, quarterly or annually.
Pros and Cons of Mutual Funds
Like all investments, mutual funds have advantages and disadvantages. Learn both the pros and cons of mutual funds so you can better decide if they should be part of your investing strategy.
Advantages of Mutual Funds
Here are some benefits of investing in mutual funds:
Diversification is the main attraction of mutual funds — they spread their investments over a variety of companies and/or market sectors, allowing investors to protect themselves against a precipitous drop in any one investment.
Potentially Low Fees
Fees on top mutual funds can be extremely low; the annual expense to own S&P 500 index funds, for example, might be as low as 0.04 percent per year. Many fund companies offer no-load mutual funds, meaning there is no commission to buy the fund.
All actively managed funds benefit from having a professional money manager invest the money according to the fund’s stated objectives. Most private investors don’t have the time or knowledge to analyze hundreds of different securities, so hiring a professional manager can be a significant advantage.
Check Out: 9 Best Vanguard Mutual Funds for Retirement
Disadvantages of Mutual Funds
Mutual funds also have drawbacks. Consider these before you invest:
Lack of Investment Control
One of the main disadvantages of a mutual fund investment is that you give up control of your investments to the fund manager. Rather than selecting your own investments, the manager buys and sells at his discretion. You might not even know what you own until the fund company issues a quarterly or annual report.
Potentially High Fees
Mutual fund fees can be high — you might have to pay for ongoing expenses or commissions to buy or sell shares. For example, the average annual expense ratio for all funds in 2016 was 0.57 percent, according to Morningstar, which means every year you owned the fund, you lost 0.57 percent of your return to fees. Some funds also charge upfront commissions of 5.75 percent or more.
Another disadvantage that open-end and closed-end mutual funds share is in their pricing. Open-end funds are priced once a day after the market closes, which means you can’t get out of the funds during the day. Closed-end funds aren’t priced at their underlying net asset values, which means some funds can sell at a large discount on the value of their underlying assets.