Guide to Understanding Mutual Funds
So you’re thinking about investing for the first time. Or maybe you’ve been investing for a while. Either way, investing can be daunting. With so much information out there, it can be difficult to separate the fact from the fluff. During your research, you may have heard of mutual funds. Some tout them as the alpha and omega of investing, while others believe they’re not worth it.
So how do you separate the good from the bad? How do you determine whether mutual funds are a good fit for your investment goals? Luckily, we’re here to help. In this guide, we’ll show you what mutual funds are, how they work, and what options you have when it comes to investing in them.
Excited? Then read on!
What Is a Mutual Fund?
The formal definition for a mutual fund is that it is a type of financial vehicle made up of a pool of funds collected from many investors and is used to invest in securities such as stocks, bonds, money market instruments, and other assets.
Simply put, mutual funds are professionally managed investment portfolios that allow investors to pool their money to invest in something.
How Mutual Funds Work
To explain how a mutual fund works, it may be helpful to first look at the traditional way of investing in the stock market.
Let’s say, for example, you wanted to invest $100 in the stock market. Now, you could choose to invest in penny stocks, and with $100, you’d be able to buy a fair amount of shares. But say you wanted to invest in a company whose current stock price hovers around the $250 mark. With $100, you wouldn’t be able to.
Now, say you and nine friends decided to each use $100 to invest and pool that money in a fund. With the pooled money, you’d now be able to buy four shares in the company. If the stock price increased to $300, that would mean that the fund has made a return of $50 per share, or $200. In turn, this would mean that each investor made $20.
Although a rudimentary example, this is precisely how mutual funds work. Instead of investing in a company whose stock forms the underlying assets, a mutual fund investor invests in a mutual fund company. Instead of a CEO, it has a fund manager that acts in the best interest of the mutual fund shareholders.
Generally, investors in mutual funds earn income from the fund in one of three ways:
- They earn dividends on the stocks and bonds held by the fund. The fund pays these out to investors as distributions.
- The fund sells the securities at a higher price. The fund also pays these out as distributions.
- The securities increase in value, and investors can sell their mutual fund shares for a profit.
Most mutual funds are part of a larger investment company that has many separate funds available for investment.
With all these options available, you may be asking, “What is a good mutual fund to invest in?” Luckily, there are many types of mutual funds available to choose from, depending on your risk appetite and what you want from the fund.
What Is an Equity Fund?
Equity funds—or stock funds—are the largest category of mutual funds. As the name implies, these funds typically invest in stocks. Fund managers often name them according to their investment strategy, the companies they invest in, or whether they invest in foreign or domestic stocks.
What Is a Growth Stock Mutual Fund?
Falling under equity funds, these funds aim to invest in younger firms or firms that fund managers expect will grow at a faster rate than the overall stock market. For this reason, these funds typically include or are based on technology stocks.
What Is an Index Fund?
Instead of choosing stocks based on extensive research, with these funds, fund managers buy stocks that correspond with major market indices such as the S&P 500 or the Dow Jones Industrial Average. Because these funds rely on less research, there are fewer expenses that lower the returns.
What Is a Fixed-Income Fund?
These funds focus on investments that pay a fixed return, such as government bonds, corporate bonds, or other debt instruments. As the fund generates income, it passes it on to the shareholders as distributions.
What Is a Money Market Mutual Fund?
Money market funds consist of safe, risk-free investments in short-term debt instruments. Due to their low risk, they also give low returns that are typically just above what you would earn with a regular savings account.
Keep in mind, though, that these are just some examples of mutual funds available, and there are many other fund types, from specialty funds to global funds, to choose from.
What Costs Come with a Mutual Fund?
All this investment goodness doesn’t come for free. Mutual funds have expenses, and they pass them to their investors as different kinds of fees. These can include charges such as shareholder fees, operating expenses, exchange fees, and account fees.
Because mutual funds have different fee structures, it’s impossible to say what investing in a mutual fund will cost. It may therefore be worth your while to do a bit of research and find a mutual fund that does well and has reasonable fees.
What Is an Operating Fee?
Annual fund operating fees, or expense ratios, are a percentage of the fund under management and include its management fee and administrative costs. So, what is a good expense ratio for a mutual fund? It’s difficult to say, but most funds have an expense ratio of between 1 and 3 percent.
What Is a Sales Charge on a Mutual Fund?
Sales charges, along with commissions and redemption fees, are shareholder fees that investors pay when buying or selling the funds. Fund managers often refer to these as loads. Thus, when a fund has a front-end load, it charges fees when investors buy shares. In contrast, when it has a back-end load, the investors have to pay the fees when they sell the shares.
What Is a No-Load Mutual Fund?
Despite these fees, some funds offer a no-load mutual fund. That means that the fund doesn’t carry any fees or sales charges, irrespective of whether an investor buys or sells shares.
Pros and Cons of Mutual Funds
Now, you may think mutual funds are fantastic because they let you invest in the stock market more easily than doing it on your own. In fact, there are many other benefits as well. However, as with anything, there are also some drawbacks to them.
Advantages of Mutual Funds
One of the main problems with investing in stocks or similar instruments with minimal knowledge and experience in doing so is the management of the investment. Investors often don’t know what to buy, when to buy, or when to sell.
And that’s the first benefit. Professional portfolio managers manage mutual funds, and they have the knowledge, experience, and resources to buy, sell, and manage investments. In addition, you can buy and sell shares on any business day, and most funds allow you to automatically reinvest interest, dividends, and capital gains to buy more shares.
Mutual funds also allow you to hold a variety of instruments at a much lower cost, which offers you diversification. Diversification lowers the overall risk in that, while one investment may decrease in value, another may increase.
Furthermore, mutual funds allow an affordable entry into investing. It also gives you the advantage of professionally managed funds with much lower investment minimums.
Disadvantages of Mutual Funds
One disadvantage of mutual funds is that, like many other investment types, the investment may decrease in value. As with any stock, mutual funds experience price fluctuations, and there’s no guarantee of performance. Another thing that can affect profits or losses is that, unlike stock that you can trade throughout the day, mutual fund redemptions take place at the end of the day.
Additionally, because many investors buy into and withdraw from the fund every day, they have to keep a large portion of their portfolios in cash. Cash that’s not invested is not making any returns, which means it lowers the overall income potential.
Unfortunately, mutual funds also come at a cost. Creating and running a mutual fund is expensive, and fund managers pass these expenses on to investors.
Evaluating returns and fees can also make comparing funds difficult. They don’t give you the option to see the sales growth, price-to-earnings ratio, earnings per share, or other information.
Differences compared with ETFs
Exchange-traded funds (ETFs) are based on the same principle as mutual funds—they pool investor funds to buy a collection of securities according to the investment objective. And, like mutual funds, investors own the shares in an ETF.
Where they differ, however, is how funds price and trade them. You trade ETFs on the stock exchange, so it’s possible to buy and sell these shares on the stock exchange at any time during the day. In contrast, you buy mutual funds through fund managers; thus, intraday trading is not possible.
This also means that you can’t make investments in ETFs for fixed amounts, as the price fluctuates during the day based on investor demand.
There you go. Now you’ve got an idea of what mutual funds are and how they work. Depending on your needs, they can be an excellent investment option, especially for first-time investors, or a valuable addition to any investment strategy.
Now we’d like to hear from you. What do you think of mutual funds? Will you invest in one? Let us know; we’d love to hear from you.
If you need more information about mutual funds or any other financial information on things like investments, retirement plans, insurance, or banking, MoneyWizard is there to help.
Frequently Asked Questions
How much risk is involved with investing in mutual funds?
As with any investment, there is some risk in mutual funds. Their performance is not guaranteed, and their price may fluctuate. They do, however, have lower investment minimums and offer diversification that somewhat minimizes the risk. Also, target-date funds that periodically rebalance asset class weight to optimize the risk and returns for a specific time frame reduce the risk compared to other mutual funds.
One way to assess the risk involved in a mutual fund is to compare its returns from year to year. If the returns are constant, then it is probably a lower-risk investment. In contrast, if the difference is substantial, the fund can be considered a higher-risk investment.
Are mutual funds safe?
Yes, mutual funds are generally considered safe. They could be a bad investment, however, when you consider things like high expense ratios, hidden front- and back-end load charges, diluted returns, or lack of control over investment decisions. These are all things that can impact the returns made on the investment.
What is the minimum investment for a mutual fund?
Some mutual funds have no minimum investment requirements, meaning that you can invest any amount you like. Generally, though, most mutual investment funds require a minimum retail investment of between $500 and $1,000.