Mutual funds are one of the most common tools investors use to build retirement savings. If you have a 401(k), a pension, a traditional individual retirement account or a Roth IRA — really, any kind of brokerage account to invest your cash — there’s a high likelihood your portfolio includes mutual funds.
What is a mutual fund?
A mutual fund pools money from multiple investors — often thousands — to invest in a range of stocks, bonds and other assets. Investors buy shares in the fund, which charges a fee for managing the investments inside it.
Mutual funds owe their popularity to the cost-effective way they give investors access to a broad range of assets that help balance risk and over time scoop up market gains. The average investor doesn’t have the expertise or cash to build a portfolio one stock or bond at a time. That’s why most lean on mutual funds to do the buying and selling for them.
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A mutual fund can be managed actively or passively, and which strategy a fund follows will influence its costs and expectations for the fund’s performance. Actively managed funds are run by professionals who often try to beat the market. Passively managed funds, such as those offered by robo-advisors, follow a predetermined strategy and hope to mimic the performance of the market.
Which strategy a fund follows will influence its costs and performance expectations
Actively managed accounts have higher fees — called expense ratios — than passive funds. They also carry higher potential rewards as well as risks: Studies show passive investing strategies often deliver better returns.
» MORE: What is a robo-advisor?
What are the benefits of mutual funds?
Mutual funds can make cash in three ways: when a fund receives dividends or interest on the securities in its portfolio and distributes a proportional amount to its investors; when a fund sells a security that has gone up in price; and when the net asset value of a fund — and thus, your shares — increases.
Mutual funds create an economy of scale. Buying a broad range of stocks and bonds would break the bank of the average American. Mutual funds pool the cash of thousands of investors, giving them a cost-effective way to benefit from gains in the market.
Mutual funds are a potent tool for diversifying retirement savings. By pooling resources, mutual funds also spread risk and give people greater choice among conservative and riskier investments, as well as a broader mix of industries and asset classes.
Types of mutual funds
There are about 8,000 mutual funds on offer with varying levels of risk and potential return. Here are some of the basics, starting with the least risky:
- Money market funds invest in high-quality, short-term debt issued by the U.S. government or corporations. Your return might not be much better than what you’d get with a savings account at a bank.
- Income funds also invest primarily in government and high-quality corporate debt, but their main objective is to provide a steady flow of income to investors. Retirees and conservative investors might be interested in these.
- Bond funds invest in, well, bonds, and their risk level depends on the creditworthiness of the bond issuers. Government equals good; shady company equals less good.
- Hybrid, or balanced, funds invest in a blend of stocks, bonds and other securities, aiming to provide a solid mix of profit and security. Many hybrid funds are “funds of funds,” meaning they invest in other mutual funds. A common example is target-date funds, the default choice of many employer-sponsored retirement plans like 401(k)s.
- Equity funds invest in individual company stocks and carry the greatest risk, as well as the greatest potential returns. Market fluctuations can drastically affect your gains or losses.
Other funds are notable less for what’s inside them than for certain features:
- Index funds track a market index, such as the Standard & Poor’s 500 or the Nasdaq. These types of funds are made up entirely of the stocks comprising a particular index, so the risk mirrors that of the market, as do the returns.
- Exchange-traded funds 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.
How to buy mutual funds
You can purchase through an employer-sponsored retirement account like a 401(k), or directly from a fund provider such as Vanguard, Fidelity Investments or American Funds. Both options, however, can limit your choices of funds.
You’ll have more choices if you open a brokerage account to begin investing. There may be a minimum deposit requirement, but some providers offer $0 minimum if you invest through an individual retirement account such as a traditional or Roth IRA, or if you set up automatic monthly deposits.