Even if you’re new to investing, you’ve probably heard about mutual funds. If you have a 401(k) plan at work or an IRA on your own, you might already own mutual funds.
But what are mutual funds? How do they work? How can you buy mutual funds? Learn the answers to these questions and more.
This guide to mutual funds will cover:
- What Is a Mutual Fund?
- Why Do People Invest In Mutual Funds?
- How Are Mutual Funds Managed?
- Understanding the Types of Mutual Funds
- What Are the Benefits of Mutual Funds?
- Common Risks Associated With Mutual Funds
- How Do I Buy Mutual Funds?
- Are Mutual Funds Right for Me?
“A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds. Each share represents an investor’s part ownership in the fund and the income it generates,” according to Investor.gov.
In other words, a mutual fund is like a basket of investments that you can buy shares in. You buy shares in the whole basket, so the investments in the basket are all represented in your shares. Suppose you purchase 100 shares of XYZ mutual fund. This fund includes shares of IBM, Microsoft, General Motors, short-term municipals bonds and long-term corporate bonds. You don’t own shares of the securities individually, but you own shares of the mutual fund which owns the individual securities.
There are several different kinds of mutual funds:
Open-end funds are the most common type of mutual fund. They are bought and sold on demand and they are not limited as to the number of shares they can offer. The price of each share in open-end funds is calculated at the end of each trading day by dividing the market value of the securities in the fund, minus expenses, by the number of shares. So, if the price of the stocks and bonds held in your mutual fund goes up, the price of the mutual fund goes up and the value of your investment increases.
Closed-end funds have a fixed number of shares that are issued at the initial public offering, or IPO. Like individual stocks, they are bought and sold on exchanges, and their price fluctuates based on supply and demand. For this reason, the price of a closed-end fund can be more volatile than that of an open-end fund.
Load funds charge a sales charge, or load, when you either buy or sell the fund. When you are deciding whether or not to purchase a mutual fund, make sure you factor in the load since it can vary and can impact the average mutual fund return. Mutual fund companies can charge as much as 8.5% of the purchase price of a mutual fund for the loan.
No-load funds do not charge a sales load, but that doesn’t mean they’re necessarily cheaper than load funds. They may charge other fees for operating expenses, so understand any fees that you will be charged when you purchase mutual funds.
“No-load funds sound tempting since you don’t have to pay a commission, but there’s plenty of ongoing fees that add up, which could make them more expensive than loaded funds,” said Chris Hogan, financial expert and author of “Everyday Millionaires.” “A no-load fund isn’t automatically a better deal just because you don’t have to pay a commission. Do your research!”
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Here’s a look at the major reasons investors choose to put their money in mutual funds:
The expression “Don’t put all your eggs in one basket” is particularly relevant when it comes to investing. If you invest all your money in one company’s stock, you could lose everything if that stock does poorly. Diversification in investing means more than just buying stock in a few different companies, though. A diversified portfolio will include stocks, bonds and cash, and will be invested in many different industries. Mutual funds typically have a diverse selection of investment in the fund already, so buying shares of a single fund can do the diversification for you. If you don’t have a large amount of money to invest, mutual funds are an effective way to diversify your investments.
Mutual fund companies hire professional fund managers to choose and monitor the investments in each mutual fund. These people are highly trained, and they spend their day watching the investments in their funds, removing those that perform poorly and replacing them with ones they think will perform better.
You can sell your mutual fund shares at any time. When you do, you’ll get the current price, or net asset value, less any fees for redeeming the shares.
You can invest a relatively small amount of money in mutual funds to start with, and you can add to your investment slowly over time.
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Mutual funds can be managed in one of two ways: actively or passively. An actively managed mutual fund has a fund manager who buys and sells investments within the fund with the goal of outperforming the market relative to a benchmark, such as the S&P 500. The performance of an actively managed fund is based on how well it does compared with the benchmark.
A passively managed mutual fund includes investments that mirror the investments in the benchmark with the goal of having the same performance as the benchmark. So a passively managed fund that uses the S&P 500 as its benchmark will include stocks in the 500 companies that make up the S&P 500 index. These are 500 of the largest companies traded on the NYSE and Nasdaq exchanges.
|Active vs. Passive Mutual Funds|
|Active Management||Passive Management|
|What the Manager Does||Manager buys and sells according to their opinion of the stock’s potential||Mirrors the stocks on an index|
|Performance||May outperform or underperform any benchmark||Equals the performance of the index|
|Examples||Vanguard Wellington, Fidelity Puritan||Vanguard 500 Index Fund Investor Shares, Fidelity 500 Index Fund|
There are five major types of mutual funds.
Bond funds may contain various types of bonds. Bonds are actually debt instruments that corporations and governments issue when they need to raise money. Bonds often pay dividends and usually don’t appreciate in value. Individual bonds will mature, meaning that the issuer will pay the investor back the face value of the bond, but bond mutual funds replace maturing bonds with new bonds to keep the fund going.
Stock funds invest in the stock of corporations. They may invest in several companies in a given industry, such as technology or energy. Or, the fund may seek to invest in new companies or those in emerging markets. The stocks may be chosen for their ability to provide income in the form of dividends, or growth in the form of price appreciation.
Money Market Funds
Money market funds invest in high-quality, short-duration investments issued by U.S. corporations or government entities. They are very safe and produce relatively low but consistent returns.
Balanced funds own both stocks and bonds in an attempt to have consistent growth in any type of market. Often, when bond returns increase, stock returns decrease, and vice versa, so a fund that holds both bonds and stocks has a good chance of growing somewhat over time.
Target-date funds hold stocks, bonds and other investments, and are bought with a specific date in mind, such as retirement. They start out with a relatively aggressive mix of investments, meaning a high percentage of stocks. As the ‘target date’ approaches, the investment mix becomes more conservative. When you’re saving for retirement, you want to take less risk the closer you are to retirement, so a target date fund is a good way to accomplish this.
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Mutual funds offer three different ways for you to earn money on your investment.
- Dividend payments: Many stocks pay quarterly or annual dividends to shareholders. If a stock that’s included in your mutual fund pays a dividend, the fund receives that dividend, and you get part of it relative to the number of shares you have.
- Capital gains distributions: When a security that’s held in a mutual fund increases in value and is then sold, the difference between the price it was bought for and the price it was sold for is a capital gain. At the end of the year, mutual fund companies distribute these gains to the shareholders of the fund.
- Increased net asset value, or NAV: If the price of the stocks held in your mutual fund increases, the value of the shares of the fund also increases. When that happens, your shares are worth more than what you paid for them, so the value of your investment has increased.
“Stocks and bonds are too much risk for too little reward,” said Hogan. “Investing in single stocks is like putting all of your retirement eggs in one basket. And the value of bonds rises and falls in the opposite direction of interest rates, so if interest rates rise after you purchase, its value drops. Mutual funds are way less risky! And there’s more return than cash. Cash doesn’t grow! Mutual funds allow you to own stock in hundreds of companies at once and spread out your risk, so if something happens in one company, your entire retirement strategy won’t go down the drain.”
Mutual funds can increase in value in these three ways, but they can also decrease in value. If the value of the securities in the fund declines, the NAV of the fund will decline. You can lose money that is invested in mutual funds, so be sure that you understand the risk you’re taking on.
All investments have some level of risk. Unlike putting your money in the bank, when you invest, you could lose some or all of your money. And when you buy a mutual fund, someone else controls the stocks your money is invested in.
Another risk associated with mutual funds is their fees. You may pay a sales charge (load) on the funds you buy. Mutual funds also charge operating fees, which can reduce the value of your portfolio. You may also pay a redemption fee when you sell shares, an exchange fee if you exchange shares in one fund for shares in another, an account fee if your account falls below a minimum, or a purchase fee when you buy shares.
Check Out: What Are Open and Closed Funds?
To buy mutual funds, you must open an account with a broker or with the fund company itself. You can use an online broker such as E-Trade or TD Ameritrade. You can use a local broker, such as an independent broker, or someone affiliated with a broker/dealer such as Edward Jones. Or, you can buy directly from the fund company, such as Vanguard or Fidelity.
Once you have an account, you can buy and sell funds by calling your broker or trading online. Each time you purchase a new fund, you should read the fund’s prospectus so you understand how the investments are selected and what the fees are.
Before you invest in mutual funds, make sure you have the rest of your financial house in order. “You should only invest in mutual funds if you’re completely debt-free (minus your mortgage) and have a fully-funded emergency fund of three to six months of expenses,” said Hogan.
Once you’re ready to invest, choose mutual funds if you prefer to have someone else make the decisions about which companies to invest in, and if you want to buy and hold your investments. The fees associated with mutual funds make them a poor choice for someone who wants to buy and sell frequently.
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Karen Doyle is a personal finance writer and a former financial advisor.