Mutual fund investors own shares in a company whose business is buying shares in other companies (or in bonds, or other securities). Mutual fund investors don’t directly own the stock in the companies the fund purchases, but they do share equally in the profits or losses of the fund’s total holdings — hence the “mutual” in mutual funds.
What is a mutual fund?
A mutual fund is an investment that pools money from investors to purchase stocks, bonds and other assets. The aim is to create a diversified portfolio beyond what the average investor can build on their own. When you invest in mutual funds, professional fund managers buy securities for you.
Active vs. passive mutual funds
A mutual fund's fees and performance will depend on whether it is actively or passively managed.
Passively managed funds invest to align with a specific benchmark. They try to match the performance of a market index (such as the S&P 500), and therefore typically don’t require management by a professional. That translates into lower overhead for the fund, which means passive mutual funds often carry lower fees than actively managed funds.
Here are two types of mutual funds popular for passive investing:
1. Index funds are made up of stocks or bonds that are listed on a particular index, so the risk aims to mirror the risk of that index, as do the returns. If you own an S&P 500 index fund and you hear that the S&P 500 was up 3% for the day, that means your index fund should be up about that much, too.
2. Exchange-traded funds can be traded like individual stocks, but offer the diversification benefits of mutual funds. In many cases, ETFs will have a lower minimum investment than index funds.
Actively managed funds have a professional manager or management team making decisions about how to invest the fund's money. Often, they try to outperform the market or a benchmark index, but studies have shown passive investing strategies often deliver better returns.
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Mutual fund types
Beyond the active and passive designations, mutual funds are also divided into other categories. Some mutual funds focus on a single asset class, such as stocks or bonds, while others invest in a variety. These are the main types of mutual funds:
Stock (equity) funds typically carry the greatest risk alongside the greatest potential returns. Fluctuations in the stock market can drastically affect the returns of equity funds. There are several types of equity funds, such as growth funds, income funds and sector funds. Each of these groups tries to maintain a portfolio of stocks with certain characteristics.
Bond (fixed-income) funds are typically less risky than stock funds. There are many different types of bonds, so you should research each mutual fund individually in order to determine the amount of risk associated with it.
Balanced funds invest in a mix of stocks, bonds and other securities. Balanced funds (also called asset allocation funds or hybrid funds) are often a “fund of funds,” investing in a group of other mutual funds. One popular example is a target-date fund, which automatically chooses and reallocates assets toward safer investments as you approach retirement age.
Money market funds often have the lowest returns because they carry the lowest risk. Money market funds are legally required to invest in high-quality, short-term investments that are issued by the U.S. government or U.S. corporations.
» Learn more: Understand the different types of mutual funds
How mutual funds make you money
When you buy into a mutual fund, your investment can increase in value in three ways:
1. Dividend payments: When a fund receives dividends or interest from the securities in its portfolio, it distributes a proportional amount of that income to its investors. When purchasing shares in a mutual fund, you can choose to receive your distributions directly, or have them reinvested in the fund.
2. Capital gains: When a fund sells a security that has gone up in price, this is a capital gain. (And when a fund sells a security that has gone down in price, this is a capital loss.) Most funds distribute any net capital gains to investors annually.
3. Net asset value: Mutual fund share purchases are final after the close of market, when the total financial worth of the underlying assets is valued. The price per mutual fund share is known as its net asset value, or NAV. As the value of the fund increases, so does the price to purchase shares in the fund (or the NAV per share). This is similar to when the price of a stock increases — you don’t receive immediate distributions, but the value of your investment is greater, and you would make money should you decide to sell.
Can you lose money in mutual funds?
All investments carry some risk, and you potentially can lose money by investing in a mutual fund. But diversification is often inherent in mutual funds, meaning that by investing in one, you’ll spread risk across a number of companies or industries. Investing in individual stocks or other investments, on the other hand, can often carry a higher risk.
Time is a crucial element in building the value of your investments. If you'll need your cash in five years or less, you may not have enough time to ride out the inevitable peaks and valleys of the market to arrive at a gain. If you need your money in two years and the market drops, you may have to take that money out at a loss. Generally speaking, mutual funds — especially equity mutual funds — should be considered a long-term investment.
How to invest in mutual funds
If you're ready to invest in mutual funds, here is our step-by-step guide on how to buy them.
» Ready to invest? NerdWallet's roundup of the best brokers for mutual funds
1. Decide whether to go active or passive
Your first choice is perhaps the biggest: Do you want to beat the market or try to mimic it? It's also a fairly easy choice: One approach costs more than the other, often without delivering better results.
Actively managed funds are managed by professionals who research what's out there and buy with an eye toward beating the market. While some fund managers might achieve this in the short term, it has proved difficult to outperform the market over the long term and on a regular basis.
Passive investing is a more hands-off approach and is rising in popularity, thanks in large part to the ease of the process and the results it can deliver. Passive investing often entails fewer fees than active investing.
» Check out the best S&P 500 index funds
2. Calculate your budget
Thinking about your budget in two ways can help determine how to proceed:
How much do mutual funds cost? One appealing thing about mutual funds is that once you meet the minimum investment amount, you can often choose how much money you’d like to invest. Many mutual fund minimums range from $500 to $3,000, though some are in the $100 range and there are a few that have a $0 minimum. So if you choose a fund with a $100 minimum, and you invest that amount, afterward you may be able to opt to contribute as much or as little as you want. If you choose a fund with a $0 minimum, you could invest in a mutual fund for as little as $1.
Aside from the required initial investment, ask yourself how much money you have to comfortably invest and then choose an amount.
Which mutual funds should you invest in? Maybe you’ve decided to invest in mutual funds. But what initial mix of funds is right for you?
Generally speaking, the closer you are to retirement age, the more holdings in conservative investments you may want to have — younger investors typically have more time to ride out riskier assets and the inevitable downturns that happen in the market. One kind of mutual fund takes the guesswork out of the “what's my mix” question: target-date funds, which automatically reallocate your asset mix as you age.
» What’s the right number of funds? Here’s our guide on how many funds to buy
3. Decide where to buy mutual funds
You need a brokerage account when investing in stocks, but you have a few options with mutual funds. If you contribute to an employer-sponsored retirement account, such as a 401(k), there’s a good chance you’re already invested in mutual funds.
You also can buy directly from the company that created the fund, such as Vanguard or BlackRock, but doing so may limit your choice of funds.
Most investors opt to buy mutual funds through an online brokerage, many of which offer a broad selection of funds across a range of fund companies. If you go with a broker, you'll want to consider:
Affordability. Mutual fund investors can face two kinds of fees: from their brokerage account (transaction fees) and from the funds themselves (expense ratios and front- and back-end “sales loads”). More on these below.
Fund choices. Workplace retirement plans may carry only a dozen or so mutual funds. You may want more variety than that. Some brokers offer hundreds, even thousands, of no-transaction-fee funds to choose from, as well as other types of funds like ETFs.
Research and educational tools. With more choice comes the need for more thinking and research. It's vital to pick a broker that helps you learn more about a fund before investing your money.
Ease of use. A brokerage's website or app won't be helpful if you can't make heads or tails of it. You want to understand and feel comfortable with the experience.
4. Understand mutual fund fees
Whether you choose active or passive funds, a company will charge an annual fee for fund management and other costs of running the fund, expressed as a percentage of the cash you invest and known as the expense ratio. For example, a fund with a 1% expense ratio will cost you $10 for every $1,000 you invest.
A fund’s expense ratio isn’t always easy to identify upfront (you may have to dig through a fund’s prospectus to find it), but it's well worth the effort to understand, because these fees can eat into your returns over time.
» How do fees impact returns? This mutual fund calculator can help
Mutual funds come in different structures that can impact costs:
Open-end funds: Most mutual funds are this variety, where there is no limit to the number of investors or shares. The NAV per share rises and falls with the value of the fund.
Closed-end funds: These funds have a limited number of shares offered during an initial public offering, much as a company would. There are far fewer closed-end funds on the market compared with open-end funds. A closed-end fund’s trading price is quoted throughout the day on a stock exchange. That price may be higher or lower than the fund’s actual value.
Whether or not funds carry commissions is expressed by “loads,” such as:
Load funds: Mutual funds that pay a sales charge or commission to the broker or salesperson who sold the fund, which is typically passed on to the investor.
» Ready to go? Here's our roundup of the best brokers for mutual funds
5. Manage your portfolio
Once you determine the mutual funds you want to buy, you'll want to think about how to manage your investment.
One move would be to rebalance your portfolio once a year, with the goal of keeping it in line with your diversification plan. For example, if one slice of your investments had great gains and now constitutes a bigger share of the pie, you might consider selling off some of the gains and investing in another slice to regain balance.
Sticking to your plan also will keep you from chasing performance. This is a risk for fund investors (and stock pickers) who want to get in on a fund after reading how well it did last year. But "past performance is no guarantee of future performance" is an investing cliche for a reason. It doesn't mean you should just stay put in a fund for life, but chasing performance almost never works out.
Mutual fund pros and cons
Still trying to decide if mutual funds are for you? Here are the pros and cons.
These are the primary benefits to investing in mutual funds:
Simplicity. Once you find a mutual fund with a good record, you have a relatively small role to play: Let the fund managers (or the benchmark index, in the case of index funds) do all the heavy lifting.
Professional management. Active fund managers make daily decisions on buying and selling the securities held in the fund — decisions that are based on the fund's goals. For example, in a fund whose goal is high growth, the manager might try to achieve better returns than that of a major stock market like the S&P 500. Conversely, a bond fund manager tries to get the highest returns with the lowest risk. If you’re interested in (and willing to pay for) professional management, mutual funds offer that.
Affordability. Mutual funds often have a required minimum from $500 to $3,000, but several brokers offer funds with lower minimums, or no minimum at all.
Liquidity. Compared with other assets you own (such as your car or home), mutual funds are easier to buy and sell.
Diversification. This is one of the most important principles of investing. If a single company fails, and all your money was invested in that one company, then you have lost your money. However, if a single company within a mutual fund fails, your loss is constrained. Mutual funds provide access to a diversified investment without the difficulties of having to purchase and monitor dozens of assets yourself.
Here are the major cons of mutual funds:
Fees. The main disadvantage to mutual funds is that you’ll incur fees no matter how the fund performs. However, these fees are much lower on passively managed funds than actively managed funds.
Lack of control. You may not know the exact makeup of the fund’s portfolio and have no say over its purchases. However, this can be a relief to some investors who simply don’t have the time to track and manage a large portfolio.