What Are Mutual Funds?
By pooling investor interests, mutual funds can make it cost-effective for ordinary investors to obtain high-level portfolio management over a diversified portfolio of securities they may not otherwise be able to invest in very easily.
Mutual funds are a convenient and cost-effective way to own large numbers of stocks or other investments. You may already own mutual funds through your company's 401(k) plan or your own accounts.
Whether you are new to mutual fund investing or have owned them for years, understanding mutual funds in general and the specific funds you are considering buying can help you make better, more informed investment decisions.
What you can learn from this article:
- What mutual funds are and how they work
- How you make money from mutual funds
- Risks of mutual funds
- How to use mutual funds
- Different types of mutual funds
What is a Mutual Fund?
A mutual fund is a company designed to pool money from multiple owners for the purpose of investing in stocks, bonds or other investments.
On your own, it could be very expensive to obtain professional investment management and put together a diversified portfolio.
Pooling money with other investors in this way reduces expenses and makes investing more cost effective. It can also help make it easier to get in and out of your investments whenever you choose.
How do Mutual Funds Work?
Mutual funds are bought, sold and owned in increments known as shares. The value of each share is determined by the value of the investments the fund holds. The more shares you own, the more you will participate in the increases and decreases in the value of those investments.
All of the key information about a mutual fund can be found in a detailed document called a "prospectus." This describes the fund's objectives and management team, lists current holdings and details financial information including fees.
A prospectus is often lengthy, but it should be reviewed if you are considering buying shares because it is the official disclosure document for information about that fund. As changes are made to the fund, the prospectus is updated so it accurately reflects the fund's objectives and pertinent information.
Mutual fund objectives
Each mutual fund is built to pursue a specific investment strategy or objective. Objectives could be set to focus on different things like risk, asset class, or latitude in the choice of investments.
A fund with a conservative objective takes fewer risks in pursuit of safety and liquidity. An aggressive objective could be achieved with a fund that invests in stocks and bonds in pursuit of higher returns despite that it entails more risk.
- Asset class
Many mutual funds are dedicated to investments in a single asset class, but some represent portfolios blending multiple asset classes.
- Lattitude of investment choice
Some mutual funds are tightly limited in the type of investments they can make, others allow themselves more latitude. The amount of investment latitude allowed may determine the extent to which you get the type of investments you think are buying.
Mutual fund management styles
An important division in management style is between actively managed funds and indexed funds. An indexed fund seeks to replicate the composition of a given investment index, such as the S&P 500, with the goal of mimicking the return of that index as closely as possible, for better or worse.
An actively managed fund uses security selection, asset allocation or other investment strategies in an attempt to beat relevant indexes and competing mutual funds. While active management creates the opportunity to do better than the index, inevitably some managers will under-perform as well.
Mutual fund fees
Fees are where things get complicated - and where you have to pay close attention when considering a given mutual fund. Most mutual fund fees are charged directly to the fund portfolio rather than to each individual investor, so they impact your return without you actually seeing them.
A mutual fund has a portfolio manager that makes investment decisions according to each fund's investment objectives. These managers charge a fee for this, and those fees are taken out of the value of the fund's investments.
There may also be distribution fees, known as 12b-1 fees, and other costs involved in owning a mutual fund too, including:
- General operating expenses
- Trading costs
- Sales charges, sometimes known as "loads"
- Redemption fees
Management fees, operating expenses and trading costs are spread equally across the fund as a whole. In this way, they are shared by all the investors according to how much of the fund each one owns. The total of fees and operating expenses per share is called the "expense ratio."
Sales charges and redemption fees are charged against the specific holdings of the individual investor.
How Do You Make Money from a Mutual Fund?
Every day, the value of all of a mutual fund's investments is calculated. Any costs are deducted, and the remaining amount is divided by the number of shares in the mutual fund. The result is known as the "net asset value" (NAV).
Essentially, the fund's price, or NAV, is the current value of the portfolio's securities net of any fees due, divided by the number of shares in the fund. This is the per-share value of the fund and is the price at which shares of the fund are bought and sold.
You can make money from a mutual fund in two ways:
- If the NAV of the fund rises from the time you buy it to the time you sell it, you will profit from that difference as long as sales loads and redemption charges don't exceed the amount of the increase.
- Income earned by the fund and the net value of all realized gains and losses within the fund are periodically distributed to shareholders as dividends. [Note that these are taxable, unless you own the fund within a tax-advantaged account like a 401(k) or an IRA.]
Funds publish a record of their past performance, usually alongside a relevant index. Keep in mind that past performance is no guarantee of future results and, in particular, performance may be misleading if it is not measured over a full range of market conditions such as rising and falling markets.
Are Mutual Funds Safe?
Mutual funds are regulated by the Securities and Exchange Commission (SEC). This regulation means they have to follow certain rules and are subject to supervision by the SEC. However, even with this regulation there are risks to owning a mutual fund.
These risks include:
- Investments made by the fund may lose value, which could result in a decline in the overall value of the fund's NAV
- The fees and expenses of the fund may exceed the income and net gains it earns
- Investment objectives, management teams and expenses may change over time, though such changes are supposed to be disclosed to a fund's shareholders
- For a variety of reasons, the fund may not perform as well in the future as it has in the past
Types of Mutual Funds
There are thousands of mutual funds designed to pursue many different investment objectives. Here are some of the major mutual fund types available:
Index funds are designed to imitate the performance of popular market indexes such as the S&P 500. The idea behind index funds is not to try to do better than the index, but to match its performance as closely as possible.
There are many indexes for stocks and other types of investments. Some of the more popular indexes have more than one index fund designed to mimic its holdings and performance. So even when you've decided which index you want to match, you may still have to choose from a slate of mutual funds all designed to match that index.
Unlike index funds, managed funds make active investment decisions in an attempt to do better than the market as a whole.
Managed funds are typically more expensive than index funds, and there is no guarantee they will succeed and outperform the market.
Exchange-traded funds (ETFs)
Traditionally, mutual funds were bought from the company that managed them, either directly or through a broker. Now some known as "exchange-traded funds" (ETFs) can be bought or sold on a stock exchange like any other stock.
ETFs have management teams, investment objectives and expense ratios just like ordinary mutual funds. However, because they are actively traded on an exchange, their prices are determined by supply and demand for the fund rather than directly based on the NAV of the fund.
Target-date funds are popular retirement investments for 401(k) plans, but they can be used in other types of investment accounts too.
The investment mix of these funds is typically more aggressive for target dates far in the future, and it gradually gets more conservative as the target date approaches.
These funds put together a mix of different investments geared toward a particular retirement date. There are plenty of funds from which to choose, so you shouldn't have trouble finding one that matches your plans.
How to Use Mutual Funds
With so many types of mutual funds available, there's naturally a variety of ways they can be used ranging from simple to complex.
You can find mutual funds that include a variety of different asset classes, so you only need to have one fund in order to get broad investment diversification.
On the other hand, many mutual funds are designed to focus much more narrowly on one particular type of investment. This allows you to build a customized portfolio with just the specific types of assets you want to own.
The mix of funds you choose can be based on either a passive or an active allocation.
Passive asset allocation means you pick a mix you want to hold for the long term. Then the only adjustments you'd need to make would be to occasionally reset that mix back to your target to account for changes in market value or additions and withdrawals to your account.
Active asset allocation means changing your mix of holdings according to your changing expectations about which assets would do best.
You can either pursue these strategies yourself or have them implemented for you. Robo-advisors are designed to set up a mix of mutual funds or other investments based on your situation and investment goals.
Online brokers can be a cost-effective way of buying and selling individual funds yourself. You can use an online broker to buy one fund that includes multiple asset classes, or to put together a mix of different funds.
If your employer offers a 401(k) plan, you can pursue similar strategies to pick funds or other investments within that plan.
Frequently Asked Questions
Here are answers to some common questions about mutual funds.
Yes, but that is highly unlikely. That's because mutual fund investments are diversified, so the risk of totally losing value is small.
However, most mutual funds do involve some degree of risk. This includes temporary price fluctuations that may be severe as well as the possibility of permanent losses.
Most funds do pay dividends which reflect both income earned and the net realized gains of the fund. These dividends can typically be received in cash or automatically reinvested in the fund. Note that even if you reinvest the dividend directly, it may be subject to taxation.
Mutual funds invested in high-yield bonds may offer the highest monthly income. However, the risk of the underlying securities may result in price declines which reduce or even exceed the income received.
Actively managed funds are generally more expensive than index funds, but there is a wide range of costs for each type of fund.
It is important to check the expense ratio for any fund you are considering and also take into account other charges such as sales loads and redemption fees that are not included in the expense ratio.