A mutual fund is an investment vehicle that pools money from multiple investors to purchase a portfolio of securities.
Mutual funds can invest in a wide variety of securities, from stocks and bonds to commodities and alternative assets like real estate, or even a combination of many different investments. The investments used will be determined by the fund’s investment objective. For example, a fund that seeks capital appreciation may hold primarily stocks, while a fund seeking income may hold more bonds.
A mutual fund works by pooling investor funds to purchase various securities. A mutual fund company hires a professional money manager to oversee these investments, called the portfolio, to maintain the fund’s investment objective.
When you invest in a mutual fund, you’re purchasing a proportional share of all the investments the fund holds, much like how each slice of a pie has the same ratio of ingredients. This is why mutual funds can be an effective means of building a diversified portfolio with a small investment: Every dollar you invest in a mutual fund is as diversified as the mutual fund as a whole.
There are many types of mutual funds, such as:
- Stock funds, which invest primarily in stocks.
- Bond funds, which invest primarily in bonds.
- Asset allocation funds, which invest in a mixture of stocks and bonds.
- Target-date funds, which are asset allocation funds that change their allocation as the fund approaches its “target date” – typically the date an investor wishes to retire.
- Money market funds, which invest in liquid, cash-like investments.
Mutual funds are similar to exchange-traded funds, or ETFs, in that both types of investments pool investor money to purchase a basket of investments. The key difference between a mutual fund and an ETF is that an ETF trades like a stock, meaning investors trade shares of an ETF on stock exchanges. With a mutual fund, you buy and sell shares directly through the portfolio manager.
This has a few consequences: First, it means that you can buy mutual funds on a per-dollar or per-share basis. With ETFs, you must always buy in share increments, but you can buy $10 worth of a mutual fund even if its share price is $500.
Trading directly with a fund manager also means you never have to worry about not being able to find a counterparty for your order. With ETFs – and many other investment vehicles – there must be someone else willing to buy what you’re trying to sell (or sell what you’re hoping to buy). A mutual fund’s manager cannot refuse to fill your order unless the fund is closed to new investors.
Since mutual fund managers are responsible for filling all orders, they may need to do more buying and selling within the fund than an ETF manager would. Mutual fund managers are also required to distribute capital gains to shareholders, so you may get an unexpected tax bill at the end of the year even if you don’t sell the fund.
Another distinction between mutual fund and ETF trading is that mutual funds do not trade throughout the day. Instead, the fund manager calculates the net asset value, or NAV, of the fund based on the fair market value of each of the investments it holds at the end of each trading day. This means when you place a trade during the trading day, you won’t know the exact price you’ll receive until after the market closes. So be careful when purchasing shares of a mutual fund.
Mutual funds can have several fees. The most common fee is the expense ratio, an annual fee charged to investors to help cover the cost of running the fund. The fee is expressed as a percentage of your investment. For example, a 0.5% expense ratio means 0.5% of your investment will go toward the fund’s operating costs rather than generating returns. This is why it’s generally best to choose investments with low expense ratios.
If the fund relies on active management, meaning the managers are actively making decisions about which securities to buy and sell in an attempt to beat an underlying benchmark, this expense ratio will be higher. Meanwhile, passively managed mutual funds that simply try to mirror an underlying benchmark index have lower expense ratios – some as low as zero.
Mutual funds can also have sales charges or sales loads. These are one-time fees you pay when you buy the fund (a front-end sales load) or sell the fund (a back-end sales load). Not all mutual funds have sales loads, so it’s best to avoid these whenever possible by investing in no-load mutual funds. 12b-1 fees, which are marketing fees taken from the fund’s assets to cover the cost of marketing and selling the fund, are also wise to avoid.
Why You Need to Know About Mutual Funds
Mutual funds can be great investment vehicles for many types of investors because of their ease of use and diversification. Most employer-sponsored retirement plans like 401(k)s use mutual funds, so you may already own one or two. If you’re just starting to invest, a mutual fund is one of the best ways to go. You can build a diversified portfolio with as little as one mutual fund – although more may be better.
As investors put more pressure on fund providers to lower their fees, mutual funds are becoming more economical. Today, you can find index funds with zero expense ratios and zero minimum investments.
- Diversification. Mutual funds can invest in hundreds or even thousands of securities.
- Low cost. Passively managed mutual funds can have expense ratios as low as 0%.
- Low minimum investment. While some mutual funds may require you to buy a certain amount on your first purchase, such as $1,000 or $3,000, many have waived their investment minimums so you can start investing for as little as $1.
- Ease of use. You can buy mutual funds on a per-dollar amount, so you never need to worry about having enough money for an entire share.
- Potentially high fees. Mutual funds can have fees beyond just the expense ratio, such as sales loads, which are charged when you buy or sell the fund. Make sure to review all fees associated with the investment before purchasing.
- Tax inefficiency. Mutual funds are generally less tax-efficient than ETFs because mutual fund managers are required to distribute capital gains to shareholders, so you may end up with a tax bill even if you didn’t sell your fund during the year.
FAQs
Mutual funds and ETFs can both be good investments. Both offer a means of getting broad diversification for a small dollar amount and can each be relatively cheap. Which type of fund is better depends on what’s important to you.
A mutual fund may be better if you want to invest in dollar amounts rather than on a per-share basis, or if you want to set up an automatic investment plan. ETFs are better if you want to be able to trade shares throughout the day or if you’re worried about taxes since mutual funds can have large year-end distributions. Both are available in actively and passively managed forms, and while active mutual funds tend to have higher expense ratios, passive mutual funds with zero expense ratios are available.
Passively managed funds are those that track an underlying benchmark index. Instead of trying to outperform the index by continually adjusting the portfolio, as actively managed funds do, the manager simply mirrors the index’s holdings. Actively managed funds try to outperform the benchmark index by making investment decisions based on their research or investment philosophies rather than just following the fund’s benchmark.
An index fund is a passively managed mutual fund that tracks an underlying index, such as the S&P 500 or Dow Jones Industrial Average. These funds tend to be very affordable because the manager is not doing any active research on which securities to buy or sell, but rather is simply following the index.
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