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A mutual fund is an investment vehicle that allows individuals to invest their money along with other investors. These funds invest in a collection of securities such as stocks, bonds and money market funds. Most mutual funds invest in a large number of securities, allowing investors to diversify their portfolios at a low cost.

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Historically, personal investment advisors have tended to work mainly with those who have large amounts of money to invest. Plus, maintaining a diversified portfolio can be unrealistic for most investors to do on their own. Mutual funds look to solve these problems and more.

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While mutual funds face fierce competition for investors’ dollars in the form of low-cost index funds and exchange-traded funds (ETFs), they still remain quite popular. Here we’ll discuss how mutual funds work, their pros and cons and answer some key questions to help you decide if these types of investments make sense for your portfolio.

How mutual funds work

A mutual fund is a type of pooled investment fund in which many people own shares. Mutual funds invest in many different companies; some even invest in the entire stock market. However, when you buy shares in a mutual fund, you don’t invest in those companies directly since you own shares in the fund, not in the companies the fund selects.

For example, imagine you invest in a tech-heavy mutual fund. That mutual fund pools the money from all its investors and invests in a number of companies. Therefore, while the fund likely invests in companies such as Amazon and Microsoft, you don’t own shares in those companies. Instead, you simply own shares in the mutual fund.

The share price fluctuates based on the net asset value (NAV) of all of the mutual fund’s assets. NAV is calculated by dividing the total value of a mutual fund’s assets (less liabilities) by the total number of shares outstanding. Thus, changes in the share price don’t reflect fluctuations in the value of a single company, but instead they reflect the net change in all of the companies in which the fund invests.

You can buy shares in a mutual fund from whichever brokerage you prefer. However, employer-sponsored retirement plans largely invest in mutual funds, so you may be invested in them without even realizing it.

Unlike ETFs, mutual funds can only be traded once per day, after the market closes at 4 p.m. eastern. Because of this, the price of mutual funds doesn’t change throughout the day; it only changes once the NAV settles after market close.

Types of mutual funds

Mutual funds come in a variety of forms. Investors have various goals; thus, different mutual funds invest in different types of securities. Here, we will cover some of those most common types of mutual funds.

Equity funds

Equity funds are the most popular form of mutual fund. As their name implies, these funds invest in equities, which is another name for stocks. Given that there are thousands of publicly-traded companies in the US, this is also a very broad category. Within equity funds are small-cap funds, large-cap funds, value funds, growth funds, and more.

Index funds

Rather than try to beat the performance of the overall market, index funds aim to simply match the performance of a given index, such as the S&P 500. This strategy requires much less research and analysis than funds that attempt to beat the market, leading to lower fees. Those lower fees have made these funds increasingly popular over the past several years.

Money market funds

Money market funds are short-term investment vehicles that usually invest in much safer securities than equity funds and index funds. These funds won’t earn a substantial return, but there is little risk of losing money. Many brokerages park uninvested cash in safe money market funds such as government bonds.

Fixed-income funds

Fixed-income funds invest in government bonds, corporate bonds and other securities that pay a set rate of return. Typically, they are actively-managed and their asset allocation can change frequently. Although they pay a set rate of return, some bonds can have high levels of risk, which can hurt returns.

Balanced funds

Balanced funds invest in a number of different securities, including stocks, bonds, and money market funds. They aim to reduce risk by providing exposure to a variety of asset classes. In some cases, these funds may have a specific asset allocation allowing investors to select investments that align with their goals.

Pros and cons of mutual funds

Mutual funds come with their share of pros and cons. Let’s take a look at both.

Pros

  • Invest in a large number of securities for diversification
  • Low minimum investment compared to personal investment advisors
  • Professional management
  • Relatively liquid

Cons

  • Fees can be high, hindering returns
  • May have a large cash position
  • Lack transparency
  • Can be complex and difficult to compare to other mutual funds

Mutual funds and taxes

Fund managers pass on earnings to investors in the form of distributions, mainly at the end of the year. As the investor, it is your responsibility to report capital gains distributions on your tax return and pay the appropriate taxes. Even if you reinvest your dividends, you are still required to pay taxes on them as they are taxed as income.

If you are responsible for taxes when tax time comes, the fund manager should issue you IRS Form 1099-DIV. One way to reduce your tax liability is to hold mutual funds in a tax-deferred investment vehicle, such as a 401(k) or IRA.

Mutual funds vs. ETFs

ETFs often work much like mutual funds, but they have some key differences. These securities track an index or other asset and can be bought and sold on exchanges like stocks. Because of this, they can also be traded throughout the day, and their price fluctuates accordingly. Fees are often lower for ETFs than for mutual funds, making them widely popular.

Both mutual funds and ETFs hold a selection of stocks and/or bonds. You may also see a mutual fund or ETF that invests in commodities or cryptocurrency, but both invest in some kind of security or asset. In addition, they are subject to similar regulations.

However, mutual funds are actively managed and only trade once per day, after market close. Their fees can be high in some cases, too.

On the other hand, ETFs trade like stocks on an exchange. As a result, they can be traded throughout the day. They are not usually actively managed and thus tend to have lower fees.

Employer-sponsored retirement plans often invest in mutual funds, while ETFs tend to be held more often by investors in an individual retirement account (IRA) or taxable account.

Bottom line

A mutual fund is a type of investment consisting of a combination of stocks, bonds, and other securities. They can invest in more than one type of security or in just stocks or bonds, for example.

The benefits of mutual funds include professional management and built-in diversification. However, mutual fund fees can be high in some cases, and they can only be traded at market close.

Here are some steps to get started with mutual funds:

  1. Research mutual funds. There are many different types of mutual funds, including those with broad exposure and those that cover a narrower niche. Thus, you’ll want to find funds that suit your strategy.
  2. Decide where to buy. All of the best online brokers offer mutual funds; you must simply decide which one you prefer. Many offer low-commission trading these days, but pay attention the fees for each broker (if any). Calculating your mutual fund fees is also a good idea.
  3. Deposit funds and buy. If you’ve already done your research, this is a simple step: just transfer money in and buy the shares you want.
  4. Manage your portfolio. Once you’ve bought your shares, there isn’t much work to do with mutual funds. However, periodic rebalancing is a good idea if you have multiple funds.

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