What is a mutual fund?
A mutual fund is an investment vehicle that pools the money of several investors buy a portfolio of securities.
Mutual fund can invest in a wide variety of securities, ranging 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 seeking capital appreciation may hold mostly stocks, while a fund seeking income may hold more bonds.
A mutual fund works by pooling funds from investors to buy various securities. A mutual fund company hires a professional fund manager to oversee these investments, called the portfolio, to maintain the investment objective.
When you invest in a mutual fund, you buy a proportionate share of all the investments held by the fund, much like how each slice of a cake has the same ratio of ingredients. That’s why mutual funds can be an effective way to build 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 several types of mutual funds, such as:
- Equity funds, which invest primarily in stocks.
- Bond funds, which invest primarily in bonds.
- Asset allocation funds, which invest in a mix of stocks and bonds.
- Target Date Fundswhich are asset allocation funds that change their allocation as the fund approaches its “target date” – usually the date an investor wishes to retire.
- Money market funds, which invest in liquid investments, similar to cash.
Mutual funds are similar to exchange traded funds, or ETF, in that both types of investments combine investors’ money to buy a basket of investments. The key difference between a mutual fund and an ETF is that an ETF trades like a stock, which means that investors trade the shares of an ETF on an exchange. With a mutual fund, you buy and sell stocks directly through the portfolio manager.
This has a few implications: First, it means you can buy mutual funds by the dollar or by the share. With ETFs, you still have to buy incremental shares, but you can buy $10 of a mutual fund even if its price per share 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 has to be someone else willing to buy what you’re trying to sell (or sell what you hope to buy). The manager of a mutual fund can only refuse to execute your order if the fund is closed to new investors.
Since mutual fund managers are responsible for executing all orders, they may need to do more buying and selling within the fund than an ETF manager. Mutual fund managers are also required to distribute capital gains to shareholders, so you could 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 net asset value, 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 that when you place a trade during the trading day, you will not know the exact price you will receive until after the market closes. So be careful when buying units of a mutual fund.
Mutual funds can have several fees. The most common rate is expense ratio, an annual fee charged to investors to help cover fund management costs. Charges are expressed as a percentage of your investment. For example, an expense ratio of 0.5% means that 0.5% of your investment will go towards the fund’s operating costs rather than generating returns. This is why it is generally better to choose investments with low expense ratios.
If the fund relies on active management, meaning managers are actively making decisions about which stocks to buy and sell with the goal of beating an underlying benchmark, this expense ratio will be higher. Meanwhile, passively managed mutual funds that simply try to mirror an underlying benchmark have lower expense ratios – some as low as zero.
Mutual funds may also have sales charges or sales charges. These are one-time charges that you pay when you buy the fund (initial sales charge) or sell the fund (final sales charge). Not all mutual funds have sales charges, so it’s best to avoid them as much as possible by investing in no-fee mutual funds. 12b-1 charges, which are marketing fees taken from the assets of the fund to cover the costs of marketing and selling the fund, are also to be avoided.
Why you need to know mutual funds
Mutual funds can be great investment vehicles for many types of investors due to their ease of use and diversification. Most employer-sponsored retirement plans like 401(k) use mutual funds, so you may already have one or two. If you’re just starting out investing, a mutual fund is one of the best ways to go. You can build a diversified portfolio with as little as one mutual fund, even if more can 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 no minimum investment.
- Diversification. Mutual funds can invest in hundreds or even thousands of securities.
- At low price. 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, like $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 basis, so you never have to worry about having enough money for an entire stock.
- Potentially high fees. Mutual funds may have fees beyond the simple expense ratio, such as sales charges, which are charged when you buy or sell the fund. Be 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 can end up with a tax bill even if you haven’t sold your fund during the year.
FAQs
A mutual fund may be better if you want to invest in dollars rather than on a per-share basis, or if you want to set up an automatic investment plan. ETFs are best if you want to be able to trade stocks throughout the day or are worried about taxes, as mutual funds can have large year-end distributions. Both are available in actively and passively managed forms, and although 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. Instead of trying to outperform the index by continually adjusting the portfolio, as actively managed funds do, the manager simply mirrors the holdings of the index. Actively managed funds try to outperform the benchmark by making investment decisions based on their research or investment philosophies rather than simply following the fund’s benchmark.