A mutual fund is a type of investment that takes in money from multiple investors and the company will invest those funds on their behalf. The main goal is to help investors invest into a wide variety of diversified investments that were selected by professionals. Mutual funds can invest into any type of investment, including but limited too, stocks, bonds, money market funds, S&P 500 indexes, real estate, international equities and so much more.
The exact make-up of the portfolio and what investments are owned is managed by the company (professional money manager) that issues/owns the mutual fund. Each share sold to an investor represents part ownership in the mutual fund, though you do not get voting rights for the underlying stock. This means if you invest in a mutual fund, you are part owner of that fund but you are not an owner of the stock, bond, or other investment that the fund bought. This concept in effect allow individuals to own a portfolio of stocks, bonds, or some other investment that is managed by one or more professionals.
Mutual funds are popular among investors because they offer professional management, diversification, affordability and liquidity. Many of them have no transaction costs as well, so they are free to buy or sell. However, it’s important to know as part of financial literacy a bit more about how mutual funds work before investing any money into them. Learn more below, or find other tips on how to start investing.
Reasons to use mutual funds
The fact is that before your invest money in something (no matter what it is!), you should take some time to understand what that investment is, how it works, the risks as well as pros and cons. This is a brief introduction to what mutual funds are and how they might fit into your investment plan or portfolio. As, like all financial products, there are advantages as well as disadvantages to them.
There are many different investment vehicles available to the average investor who is maybe trying to plan for retirement, invest for a certain goal or maybe to save for their child’s education. Mutual funds are well suited for someone who doesn’t have the time, knowledge or inclination to study individual stocks, bonds, international equities, or other types of investments.
Simply put, a mutual fund is a professionally managed pool of money from many different investors that is used to buy stocks, real estate, commodities, bonds, the entire S&P 500 or Down Jones Industrial or Nasdaq index, or other investments. Or a combination of those investments. Each fund and money manager may take their own approach to what is owned in the fund.
When you invest in a mutual fund, you are buying a share of that fund instead of a share of an individual stock or bond. The company that operates the fund may manage millions or billions of dollars in a diversified portfolio. Many funds holds hundreds of different securites for diversification. While the makeup of each mutual funds vary, they can invest in stocks, bonds, money markets, commodities, international stocks, or a combination of those various securities. Perhaps the most important feature (as well as biggest pro), however, is that it is professionally managed. Some mutual funds are more actively managed than others, but have some sort of annual fee charged for managing the purchase and sale of securities.
Depending on where your mutual funds are held, the gains or dividends you receive (on a quarterly or annual basis) are subject to income or capital gains tax at the federal, state or local level. This tax for capital gains is normally less than normal income, as the government wants to incentivize investing. However most dividends are taxed at normal income (unless it is a municipal bond fund). These capital gain tax benefits (as the rate is lower) for investments are one of the reasons that so much wealth is built through investing. However if the mutual fund is held in a retirement account, such as a 401K, IRA, Self-Employed Pension (SEP), pension, or other retirement vehicle, the tax implications are much different
One additional note to take into consideration with mutual funds is thdiverat they have drastically different levels of risk, depending on the underlying securities they’re investing in. Mutual funds that invest heavily in small-cap stocks or internet companies, for instance, have much greater volatility than a mutual fund that focuses on corporate bonds. Or if you want to follow an entire index, such as the S&P 500 or Russell 2000, there are funds that track an entire index as well.
Since mutual fund information is standardized, it’s relatively simple to tell how much risk investing in a certain funds carries. You can also very easily compare them using brokerage tools, financial literacy websites or third party companies like Morningstar. If you have questions regarding the risk level, and possible returns with the fund, reach out to a professional with the broker you’re interested in. They often provide free financial advice, especially to potential investors.
Types of Mutual Funds
There are hundreds of companies that create funds to invest in and there are thousands of different mutual funds out there. They tend to come in categories though. Some examples are below. Or read about exchange traded fund investments (ETFs).
– Stock/equity funds invest in various corporate stocks (equities). However, there are different types of funds. For instance, income funds focus on stocks that pay regular dividends, while growth funds invest in stocks that have a high potential for above-average gains. There are international investments, aggressive and conservative mutual funds, or those that mix bonds and equities. There are also index funds for tracking popular market indexes like the S&P 500, as well as sector funds that specialize in specific industries. There are thousands of different types, however there are many ways to find or compare them using Morningstar or other brokerage tools.
– Bond funds are often considered less risky because of their focus on corporate debt, and debt will always be repaid before other creditors if/when a company struggles or even goes bankrupt. They can be decent source of income from the interest earned. Of course, the level of risk varies from one bond fund to another, depending on which types of bonds the fund is focused on. There are high yield, emerging market bond funds, US government debt (such as treasuries), municipal bonds, and more.
– Balanced Funds These blend stocks and bonds as noted above. The mutual fund provider will balance the two investment types (stock and bonds) and stay within a certain percentage range, such as 60% stock and 40% bonds. Though the make up always varies. The blend of a balanced fund tends to give even more diversity.
– Money market funds are considerably less risky. They’re highly regulated and are only allowed to invest in short-term investments of the highest quality, such as U.S. Treasury bills and commercial paper.
– Target date include stocks, bonds and various other investments. Depending on the fund’s strategy, the particular mix may shift over time. These funds are well-suited for individuals who may be looking toward a particular retirement date.
There are countless other types of mutual funds. There are international, commodity, specialty (such as Real Estate or commodity) and literally thousands of others. Many even blend one or more investment types together in the fund. They really are an excellent investment vehicle because they are inherently diversified, giving you a good portfolio that requires minimal management on your part. To help find an investment, use a free mutual fund screener tool from Morningstar or other brokers.
It’s easy to find mutual funds to invest in; do a quick internet search and you will find as many different mutual funds as there are banks and brokers. Or use databases from Morningstar, Yahoo or Google Finance, discount brokerages such as Schwab, Fidelity, Ameritrade, Robinhood or Etrade, or just general internet searches.
Since mutual funds are primarily designed to be long-term investments (meaning there will likely be disadvantages do how often you can buy or sell shares in the fund), you shouldn’t have an issue finding a fund that has no trading fee. Most online brokerages offer them as well as financial advisors.
The Advantages and Disadvantages of Investing in Mutual Funds vs. Other Investments
Mutual funds are great types of investments with low entry level costs, but they are not perfect (as nothing is). They are far from being the kings of investment vehicles. Let us look at the good and bad of mutual funds. As there are pros and cons.
In terms of benefits and pros, mutual funds provide the investor with professional management of their assets and hard earned money. Decisions regarding which securities to buy or sell are left in the hands of people who know what they’re doing, giving the investor less to worry about.
A huge pro to using them is that funds are also fairly easy to buy and most have low minimum investment requirements. This makes it easier for lower income families teenagers, single moms, or those without a lot of money to get started. Many funds have a very low minimum investment requirement, even as low as a few dollars. Read more on low income families investing.
Most of them invest in a large number of different securities, depending on their particular focus, reducing the risk level for investors as they are diversified. When dividends are declared, they can be reinvested back into the fund, toward the purchase of additional shares.
A major benefit of investing in mutual funds involves its provision for diversification. As part of personal financial literacy, it is always great to diversify your assets, income, debts, and any financial obligations. Mutual funds pool funds in order to purchase shares of stock, bonds, etc. By investing in a mutual fund, your funds essentially become a part of that pool.
Now your funds are spread over several different investments just by becoming part of the fund pool. This, in turn, spreads the risk associated with the investments that make up the mutual fund. To achieve the same effect on your own, you would have to spend a lot more building your own diversified portfolio. That may prove difficult as well as costly, especially if you do not have the expertise to create such a portfolio. There are also much higher transaction costs if you tried to create your own diversification.
With a mutual fund, you do not have to worry about needing a lot of investment knowledge. Managers of mutual funds do all the research in regards to selecting the best investments, whether they are stocks, bonds, or something else for the fund. They work diligently to create a portfolio that minimizes the risk and maximizes the rewards through diversification. Their years of investment experience provide them with insights that a novice would simply not possess. In addition, if you do not like how the managers run their fund, well, you can just get out.
For some investment instruments, turning your shares into cash takes time. Mutual fund managers have a plan that makes shares in the fund much more liquid. Typically, a portion of a fund portfolio is cash specifically set aside to pay out withdrawals. When an investor decides to sell their shares in the mutual fund, they receive the funds quickly. The cash can usually be given to them, or deposited into their brokerage account, within a day.
Mutual funds have a number of other advantages; they require very little time or effort on the part of individual investors, they are managed by financial professionals who (theoretically) are more knowledgeable, and they report a standard set of information to allow for easy comparison. They are also generally well diversified, and can include index funds as well such as S&P 500 index.
When it comes to disadvantages and cons, poor fund management and unethical trading practices are always a possibility. As just because a professional manages your money and the fund, it does not mean they are good at what they do. Review the past performance before investing with a company or manager. Or invest into an index fund so the ability or performance of the manager is not as relevant. Note that mutual funds are also not Federal Deposit Insurance Corporation (FDIC) insured, and while very rare, this does open up a slim possibility for low from unethical providers; this is why it is best to open an account with a well known brokerage like Fidelity.
Performance is always a concern with investing in a mutual fund, but that is also true of almost any investment – even when selecting a financial advisor. There can be a disadvantage regarding the fund’s management. Mutual fund managers do not always get it right.
Even with years of experience, data available to them, educations, and hours of research, they may choose the wrong investment mixture at the wrong time. They may choose to invest in a sector that is primed for a fall. Then, there exist those managers that intend to take advantage of investors in their funds. Your best bet is to be cautious in which mutual funds you choose to invest in and research managerial history when you find one you like. In fact, many of them do not do as well as the overall market and their returns are lower than say the S&P 500 or other indexes.
Expense ratios and sales charges are also something every investor should view with caution, since these recurring fees (called expense ratios) can significantly affect one’s returns. There also may be costs involved when you buy a fee (called a “front-load” or when you see the fund (called “back end load”). Mutual Funds tend to have higher annual fees than ETFs. Additionally, mutual funds are only traded once per day, at the market’s closing. As a result, investors desiring quick trade executions tend to avoid them.
There are fees, but they tend to be lower than investing on your own or other options like Hedge Funds. Costs are a part of running any type of business. In a mutual fund, these costs are passed on to investors through fees. With that said, a fund with higher costs will have to outperform one with lower costs in order to generate comparable returns.
They collect their fees in other ways, as noted above. If you have a particular bank, online or offline stock broker that you like and trust, look into the mutual funds they offer, but feel free to look elsewhere too. It’s often a good idea to have several different investments with different managers, just in case one of them goes out of business for some reason.
Even a seemingly insignificant difference in fees can affect your long-term returns greatly, especially if you’re investing for retirement or more long term goals as part of your financial literacy program. There are mutual fund analyzer tools available online, including Morningstar or tools from your broker, like Etrade, Goldman Sachs, Vanguard, Fidelity and others. The free tools that can help you compare the costs of different mutual funds. They’re simple to use and in a few short minutes you can figure out how to save yourself lots of money. But in general, index funds will always have the lowest fees, in particular S&P 500 funds.
However, they are less flexible and less customizable than a portfolio built with individual securities. Some schools of thought also believe that an active manager may lead to worse returns over time; especially due to the annual fees for a fund. For lower fees, or to follow the overall stock market returns, consider investing in index funds that simply track indexes like the S&P 500.
The biggest disadvantage to investing in mutual funds lies within the fee structure. While there are no transition fee funds, some of the investments charge fees whenever you choose to buy or sell shares. In it generally best to stay away from those. In addition, for the time you own shares, you will have to pay fees associated with the maintenance of the portfolio. Shareholder and annual operating fees can eat into any profits to realize will invested in a mutual fund – they reduce the annual return of the fund. They can also magnify your losses, since you pay these fees regardless of the fund’s performance.
In the quest of the mutual fund manager to minimize risk as much as possible, they may risk exposing the fund to over-diversification. A portfolio consisting of too many closely related investments may defeat the purpose of investing in a mutual fund. The value of the fund’s shares will move in accordance to the value of the investments. Therefore, if that portion of the fund takes a significant hit, then the mutual fund itself will suffer the same fate. There will not be enough offsetting investments to cushion the blow. Screening tolls from websites including Morningstar help give visibility into what whether the individual mutual fund is not diversified enough.
Mutual funds can be an excellent choice for starting an investment portfolio as part of building a financial literacy plan, whether you are just starting out or an experienced investor. They provide an easy entry point for beginning investors to build their wealth. However, they are not perfect investment vehicles. Like everything in life, they have pros and cons. Research mutual funds to minimize expenses paid and maximize value. Management styles and fees differ from fund to fund. Use mutual fund screeners like those offered by Yahoo! Finance and Morningstar to help narrow your search. Do not rush into any investment and try to stay as informed as possible. You can only benefit in the end.
Buying and Selling Mutual Funds
Shares in a mutual fund are purchased either through a broker (like Fidelity), an online app or from the fund company itself, such as Vanguard There is also technology and smartphone apps including Acorns, Robinhood and others. Or use apps for younger investors such as Acorns or Robinhood. There are dozens of online as well as offline brokers that allow you to buy and/or sell mutual funds.
Once an account is opened and money is deposited into the account, that money can be used to purchase shares. The investor’s price for the fund includes the net asset value (NAV) of each share and any fees that the fund might charge at the time of purchase. Shares can be sold back to the fund at any time, at which point money from the sale (minus fees) is returned to the original account.
When seeking to invest, many entry level as well as advanced investors look to mutual funds as a great way to invest. There are trillions of dollars invested in this marketplace. At first glance, mutual funds provide an “almost” hassle-free path into the world of investing. They can be great for beginners to “cut their teeth” in the investment world.
You can purchase a variety of investments for a relatively small amount of money, even using a technique called dollar cost averaging to slowly but steadily buy. Good managers stand behind mutual funds, performing the calculations and the due diligence necessary to find the best stocks, bonds, etc. Moreover, when you are ready to let your mutual funds shares go, you can simply sell them and take your money elsewhere. This makes it easier for you to sell and get your cash out of the markets. Read more on buying funds from dollar just averaging.
When you purchase shares in a mutual fund, you’re acquiring a stake in all of its stocks, bonds or other securities for a relatively low initial investment. If you’re looking to diversify without investing as much time or money in the process, mutual funds can seem like a great alternative to individual securities.
However, mutual funds still carry some level of risk and poor management or unfavorable economic conditions can still cause your investment to decrease in value. Ultimately, the investor who takes the time to read his fund’s prospectus, regular shareholder reports and the latest news headlines is the one who is best prepared to weather any storm.
By Jon McNamara