What is a mutual fund?
Mutual funds pool money from investors to purchase stocks, bonds and other assets to create a diversified portfolio beyond what the average investor can build on their own: Rather than buy individual securities, professional fund managers do it for you.
Mutual fund investors own shares in a company whose business is buying shares in other companies (or in government bonds, or other securities). Mutual fund investors don’t directly own the stock in the companies the fund purchases, but share equally in the profits or losses of the fund’s total holdings — hence the “mutual” in “mutual funds." Investors buy shares that rise or fall in value based on the performance of the fund’s underlying securities. Mutual fund share purchases are final after the close of market, when the total value of the underlying assets are valued. The price per mutual fund share is known as its net asset value, or NAV.
Why invest in mutual funds?
More than 100 million Americans invest in mutual funds, according to the Investment Company Institute. Retail investors are drawn to mutual funds because of their simplicity, affordability and instant diversification these funds offer. Rather than build a portfolio one stock or bond at a time, professional managers behind each mutual fund do it for you. Also, mutual funds also are highly liquid, meaning they are easy to buy or sell.
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How mutual funds make you money
When you invest in a mutual fund, cash or value can increase from three sources:
Dividend payments: When a fund receives dividends or interest on 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.
Capital gain: 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.
Net asset value (NAV): As the value of the fund increases, so does the price to purchase shares in the fund (known as 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.
Mutual funds can lose money, too
All investments carry some risk, and you could lose money in a mutual fund. But diversification is inherent, meaning you’ll spread risk across a number of companies or industries. Investing in individual stocks, on the other hand, can carry a higher risk.
Time is a crucial element in building the value of your investments. As noted above, don’t invest cash you will need in five years or less, because you’ll want to ride out the inevitable peaks and valleys of the market.
» Find safe investments: Here's a list of low-risk investment options to consider for your portfolio.
Buying a mutual fund in 5 steps
Decide whether to go active or passive. Costs and performance often favor passive investing.
Calculate your budget. Different mutual funds have different minimum investments, so this can help decide which mutual fund to buy..
Decide where to buy mutual funds. Find the right broker that offers the right fund for your budget.
Understand and scrutinize fees. A broker that offers no-transaction-fee mutual funds can help cut costs.
Build and manage your portfolio. Check in on and rebalance your mix of assets once a year.
Step 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. These funds are more expensive because of the human touch involved.
A more hands-off approach called passive investing is rising in popularity, thanks in large part to the ease of the process and the results it delivers. Passive investing is best for most people because the funds are cheaper and there are fewer fees.
Perhaps the signature passive investment is the index fund, which buys a basket of securities meant to represent an entire market. For example, the holdings in a Standard & Poor's 500 fund mirror those in the popular index of 500 stocks, and the fund's performance is meant to replicate the performance of the index itself.
So when you hear that the S&P 500 was up 3% for the day, that means your index fund was up, too. And since there's no real management going on, its fees are lower than for an actively managed fund.
» Want to know about passive investing involving robo-advisors? Learn more about this automated way to manage your portfolio
Step 2. Calculate your budget
Thinking about your budget in two ways can help determine how to proceed:
How much do I need to get started? Mutual fund providers often require a minimum amount to open an account and begin investing. Some brokers have no account minimum; others can range from $500 to $3,000.
How should I invest that money? As mentioned earlier, the great advantage of mutual funds is the low-cost way they offer to build a diverse portfolio across stocks (for growth) and bonds (for lower but steadier returns). 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 will want to have — younger investors have more time to ride out riskier bets and inevitable reversals. 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.
» Have a small amount to work with? Here's how to invest $500
Step 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 Funds. But each of these options may have a limited choice of funds.
Most investors would be wise to buy from an online brokerage, many of which offer a broad selection of mutual 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. There are many other types of funds available, such as exchange-traded funds, or ETFs, which offer the diversification benefits of mutual funds but can be traded like individual stocks; and target-date funds, which invest in other mutual funds and reallocate their assets to become more conservative over time.
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.
» Learn more: Understand the different types of mutual funds
Step 4. Understand and scrutinize mutual fund fees
Back to the active-versus-passive question: Generally speaking, the service level of actively managed accounts will be higher, but so will the fees you pay.
» How do fees impact returns? This mutual fund calculator can help
Either way, 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, known as the expense ratio. For example, a fund with a 1% expense ratio will cost you $10 for every $1,000 you invest.
These fees aren't always easy to identify upfront, but it's well worth the effort to understand, because they can eat into your returns over time.
Another common expense are sales loads. These are commissions paid at the time of share purchase (front-end loads) and when redeemed (back-end loads). Sales loads are compensation paid to financial professionals, such as a broker or investment advisor, to buy mutual fund shares.
Step 5. Build and 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 smart 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" — and it's an investing cliché for a reason. It doesn't mean you should just stay put in a fund — go on, shop the funds offered by your broker to see if you can find something similar for less — but chasing performance almost never works out.
» Ready to go? Here's our roundup of the best brokers for mutual funds
Learn more: How do mutual funds work?
No matter which category a mutual fund falls into, its fees and performance will depend on whether it is actively or passively managed, as noted above.
Passively managed funds invest according to a set strategy. They try to match the performance of a specific market index, and therefore require little investment skill. Since these funds require little management, they will carry lower fees than actively managed funds.
Two types of mutual funds popular for passive investing:
Index funds track a market index, such as the S&P 500 or the Nasdaq. These funds are made up of the stocks of companies listed on a particular index, so the risk mirrors that of the market, as do the returns.
Exchange-traded funds (ETFs) can be traded like individual stocks but also offer the diversification benefits of mutual funds. They generally charge lower fees than traditional mutual funds, but active traders might find their costs too high.
Actively managed funds have a manager or 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.
Mutual funds: The pros
Mutual funds are one of the top tools Americans use to grow their wealth and save for retirement. About 104 million individual Americans had $21.3 trillion invested in mutual funds in 2019, according to the Investment Company Institute.
Why do so many investors consider mutual funds a good investment? There are five 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 do all the heavy lifting.
Professional management. 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.
Affordability. Mutual funds often have a required minimum between $500 and $2,500, but many brokers waive minimums if you make monthly direct deposits to buy more fund shares.
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 fails within your portfolio of many companies, then your loss is constrained. Mutual funds provide access to a diversified portfolio without the difficulties of having to purchase and monitor dozens of assets yourself.
» Interested instead in DIY investing? Understand how to buy stocks
Mutual funds: The cons
The main disadvantage to mutual funds is that, because the fund is managed, you’ll incur fees no matter how the fund performs.
Fund investors usually pay an annual fee for the running of the fund, known as an expense ratio, which is based on a small percentage of the total value of your shares (typically between 1% and 3%). Paying attention to account minimums and fees can be an important way to choose among mutual funds. (We’ll cover more on fees below.)
Also, some people don’t like the lack of control with a mutual fund; 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.
Mutual fund types
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 carry the greatest risk alongside the greatest potential returns. Fluctuations in the 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. Equity funds are the most popular type of mutual fund, according to the Investment Company Institute.
Bond (fixed-income) funds are 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 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
Mutual fund fees you need to know
Mutual funds come in four different structures that will impact fees you’ll pay:
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 IPO, much as a company would. There are far fewer closed-end funds on the market compared with open-end funds.
Whether or not funds carry commissions are 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 in addition to the NAV share price.
The good news is you can sidestep these fees by investing with a broker that offers a list of no-transaction-fee mutual funds.
» Examine the cost: Mutual fund fees - A guide for beginners