What Are Mutual Funds? The Ultimate Guide

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If investing products were desserts, mutual funds would be the mixed berry pie. Like that pie, a mutual fund is a collection of different ingredients – in this case, different types of investments such as stocks and bonds – held within the crust of the fund portfolio. When you buy a share of a mutual fund, you’re essentially buying a slice of that pie.

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Each mutual fund slice is a prorated share of all the investments that make up the fund’s pie. So if the fund is 6% Apple (ticker: AAPL) and 3% Coca-Cola Co. (KO), your slice will also be 6% Apple and 3% Coca-Cola.

You don’t own the individual ingredients or underlying investments that make up your mutual fund slice, but rather a share of the entire pie. In other words, if you purchase a share of a fund that invests in Apple and Coca-Cola, you don’t own individual stocks of Apple and Coca-Cola themselves but rather a share of the fund.

If you’re interested in learning more about investing in mutual funds, this ultimate guide covers the most important things to know:

  • What is a mutual fund?
  • What are different types of mutual funds?
  • Why should you invest in mutual funds?
  • Should you invest in passive or active mutual funds?
  • What fees do mutual funds have?
  • How are mutual funds taxed?
  • How do you choose a mutual fund?
  • How do you buy mutual funds?
  • Should you buy exchange-traded funds or mutual funds?
  • How do you sell mutual funds?

What Is a Mutual Fund?

A mutual fund is a company that pools investors’ money together to invest in a wide range of different securities. The collection of holdings that make up the mutual fund is called the portfolio.

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“A mutual fund can give investors exposure to many different asset classes and companies, including – but not limited to – stocks and bonds, at a lower buy-in cost than if they were to have bought shares of common stock in each of those companies,” says Jordan Sowhangar, a certified financial planner and vice president and wealth advisor at Girard.

The mutual fund company hires a fund manager who will invest according to the fund’s investment objective. For example, a long-term bond fund may have an investment objective of generating income for its shareholders. Meanwhile, a large-cap growth mutual fund may seek capital appreciation.

Sowhangar recommends investors review the fund’s prospectus to know its true investment objective and, more importantly, to determine the purpose of a particular fund in your overall investment portfolio. Ask yourself: “What role does this fund play in the portfolio?” Sowhangar says.

“The investor essentially needs to make sure that the investment objective of the fund aligns with what the role of the fund should be to them,” she explains.

The investment objective dictates the types of investments the fund manager selects. With the bond fund, for example, that manager probably invests primarily in longer-term-maturity bonds, while the large-cap growth manager invests primarily in large-capitalization companies.

The mutual fund’s investment strategy can be narrow or broad in its focus depending on your target market.

“The portfolio could be an aggregate market allocation to capture all stocks or bonds of the world, region of the globe, or even segment or specific theme in the economy,” says Brian Vendig, president, at MJP Wealth Advisors, in Westport, Connecticut.

Vendig points to some examples like the Vanguard Dividend Growth Fund (VDIGX), the Fidelity 500 Index Fund (FXAIX), the Pimco Income Fund (PIMIX) or the T. Rowe Price Blue Chip Growth (TBCIX).

A fund may invest outside of its primary asset class to meet its objective. For example, the long-term bond fund may invest 80% in long-term bonds and 20% in shorter-term bonds or other asset classes. This latitude can be a good thing because it allows a fund to be more dynamic. But it’s also something to watch out for, as it can lead to overlapping on funds

A fund’s investment strategy will detail the degree to which a fund manager may deviate from the core asset class. The investment objective and investment strategy appear in the fund’s prospectus, a legal document fund providers file with the U.S. Securities and Exchange Commission and give to all new investors.

What Are the Different Types of Mutual Funds?

With thousands of mutual funds to choose from, whatever your investment tastes may be, chances are there’s a fund flavor to match. But all this selection can make it even harder to find the best mutual fund for you.

A good place to start is with the fundamentals. All mutual funds fall into one of six fundamental categories based on what they invest in:

  • Stock funds invest primarily in stocks.
  • Bond funds invest primarily in bonds and other sources of fixed income.
  • Asset allocation funds invest in both stocks and bonds.
  • Money market funds invest in liquid, short-term bonds intending to give investors a cash alternative.
  • Commodity funds invest in commodity-related companies, such as energy or mining companies.
  • Alternative funds invest in alternative assets outside the stock-bond spectrum and often use complex trading strategies.

Mutual funds typically specialize in a particular area within their broader category, such as long-term bonds or international stocks.

Balanced funds are a type of asset allocation fund that invests in a balance of stocks and bonds, commonly 60% stocks and 40% bonds. Other asset allocation funds also invest in different ratios of stocks to bonds, such as 80% stocks to 20% bonds or a 50/50 split, but they’re not considered balanced funds. The allocation doesn’t change over time. So a 50/50 fund will always be 50% stocks and 50% bonds.

Target-date funds, also called life cycle funds, on the other hand, change their allocation depending on how close they are to their target date. A target-date fund begins by investing in assets with high potential returns and then gradually becomes more conservative as the target date nears.

Most target-date funds start out investing primarily in stocks. As the target date nears, the fund increases its allocation to fixed income to reduce its risk level. Although conventionally thought of as retirement products, target-date funds can be used to plan for any financial goal with a set time frame.

Why Should You Invest in Mutual Funds?

Instant diversification. A mutual fund may invest in hundreds or even thousands of stocks and bonds, also known as securities. One advantage of mutual funds is that they help reduce investment risk through their inherent diversification.

“By rule, a mutual fund is required to be diversified such that the economic failure of a single company does not implode a portfolio,” says Mike McKeigue, managing director and head of business development at TortoiseEcofin.

Instead of trying to put together your own diversified portfolio of stocks and bonds, you can buy shares in a mutual fund and gain instant exposure to hundreds or thousands of securities. Because each share is prorated across all of the fund’s holdings, every share is diversified.

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Low minimum investment requirements. While most mutual funds have minimum investment requirements, they tend to be low – about $1,000 to $2,500. Some funds have lower minimums or will waive them for investors who buy shares within an employer-sponsored retirement plan or sign up for the fund’s automatic investment plan.

Professional management. Another benefit of mutual funds is having access to professional management through the fund manager. The degree to which the manager makes those decisions depends on whether the fund is actively or passively managed.

Should You Invest in Passive or Active Mutual Funds?

Actively managed funds have a portfolio manager who actively selects which investments to buy and sell to outperform some underlying benchmark, such as a market index.

Comparatively, a passive mutual fund simply aims to match its benchmark, not outperform it. The fund’s sole objective is to mirror the performance of the index it tracks by holding the same investments in roughly the same proportion as the index. A passive fund manager doesn’t actively select stocks or bonds to buy and sell, which is why passive funds tend to have lower expense ratios than actively managed funds.

What Fees do Mutual Fund Have?

Mutual funds can have a few different fees. The most recognized mutual fund fee is the expense ratio.

An expense ratio is an annual fee that funds charge shareholders. It’s expressed as a percentage of the assets under management and is deducted from the fund each year to cover its costs.

The expense ratio is used to cover those maintenance costs of the fund. Because the expense ratio is deducted from a fund’s earnings, it reduces the return shareholders receive.

“Do not choose your mutual fund based on the fee,” says Jim Pratt-Heaney, founding partner at Coastal Bridge Advisors. Rather, Pratt-Heaney says you should look beyond the management fee and see what the total fee is because oftentimes funds tag on hidden charges.

“Find out how the fee compares to other funds in the asset class, and if out of line, find out why. A high fee for a fund that has better performance can be worth it,” he says.

Average expense ratios for equity mutual fund was about 0.5% in 2020, according to the Investment Company Institute, but specialty or international funds can be more expensive.

Whether you choose to invest in an active or passive mutual fund depends on your preference and philosophy. If you believe a manager can outperform the market, you may be willing to pay the higher cost of an active fund. If you don’t believe it’s possible to reliably beat the market, or you are more concerned with keeping costs low, a passive index fund may be better.

Another mutual fund fee you may encounter is a sales charge or sales load. Unlike the expense ratio, sales loads are not recurring expenses. Instead, you pay it when you buy (a front-end sales load) or sell (a back-end sales load) the fund.

Not all mutual funds have a sales load charge. In general, it’s best to avoid them by choosing no-load mutual funds.

Jan Blakeley Holman, director of advisor education at Thornburg Investment Management, based in Santa Fe, New Mexico, says it’s important for investors to compare expense ratios between two similar funds that follow the same benchmark.

“When it comes to comparing actively managed funds that have the same investment objectives or goals and appear to invest in the same types of securities, it’s important to dig further to determine whether there are other key reasons for expense ratio differences,” she says.

How Are Mutual Funds Taxed?

Mutual funds are less tax-efficient than ETFs because investors buy and sell shares through the fund manager. This forces the manager to do more buying and selling within the fund. Since mutual funds are required to distribute capital gains to shareholders, this can create an unexpected tax bill for investors.

If the capital gains are short-term, meaning the fund manager sold an investment that the fund had held for less than 12 months, you’ll pay ordinary income rates on the distribution. Long-term capital gains are taxed at the lower capital gains rate.

If your fund pays a dividend, you’ll also be taxed on this. Dividends are taxed as ordinary income unless certain IRS qualifications are met. Investors must pay taxes on any dividends received, even if you reinvest those dividends.

To avoid paying taxes on mutual fund distributions in the year they are received, hold the fund in a tax-deferred account, such as a traditional individual retirement account or 401(k). With tax-deferred accounts, you won’t pay taxes until you withdraw the money from your account.

How Do You Choose a Mutual Fund?

Your mutual fund choice should depend on why you’re investing. Start with your goals so you don’t get distracted by funds that may be good investments but won’t help you reach your goals.

When choosing a mutual fund, McKeigue says investors should consider the four Ps: people, philosophy, process and performance.

Know who the portfolio managers are and what they bring to the table. Look at their professional background and experience level to determine if they qualify to make the fund’s management decisions.

Philosophy, McKeigue says, is the portfolio manager’s style or investment approach, process is the methodology used when putting the portfolio together and performance is how the portfolio has fared in different market conditions.

Sowhangar says another factor to consider is the fund’s longevity.

“Although never a guarantee, a fund that has been around for a longer time period can provide more insight as to how it may perform in certain market environments in the future, while a new fund has very little historical data to provide to help you make an informed decision,” she says. This context can be helpful for a “buy and hold” investor.

Once you’ve found a fund that meets your objectives, it’s time to place a trade.

How Do You Buy Mutual Funds?

Investing in mutual funds works a little differently from other investments. Investors buy and sell mutual funds directly through the fund manager. To purchase shares of a mutual fund, you enter the trade the same way you would for a stock, but it’s the fund manager who receives the request and issues your shares.

Mutual funds can be purchased on a per-share basis or in a specified dollar amount. For example, you could buy 100 shares of a fund or you could buy $1,000 of the fund. This is possible because fund managers are willing to sell fractional shares.

The price per share is determined by the fund’s net asset value. NAV is calculated by adding up the current value of the fund’s holdings, subtracting the fund’s expenses and then dividing by the number of shares investors hold, or shares outstanding. The fund manager calculates a fund’s NAV each trading day at the market close.

Investors receive the next available NAV. So if you place a trade at 11 a.m., you’ll receive that day’s closing NAV. If you place a trade after market close, you’ll get the next day’s NAV. You won’t know the exact price per share you’ll pay for your mutual fund until the next market close.

Should You Buy Exchange-Traded Funds or Mutual Funds?

This is one of the key features that set ETFs apart from mutual funds. Structurally, ETFs and mutual funds are similar: Both are investment companies pooling investor money to buy a collection of securities according to an investment objective. Investors own prorated shares of the investments within an ETF just as they do with a mutual fund.

Where ETFs and mutual funds diverge is how they’re traded and priced. ETFs trade like stocks, meaning investors can buy or sell ETFs on an exchange throughout the trading day instead of purchasing shares directly through the fund manager. As a result, ETFs can’t be bought in specified dollar amounts because an ETF’s price will fluctuate throughout the day based on investor demand.

This means you don’t have to wait until the market closes for the manager to calculate the NAV to know how much you’ll pay for your ETF. You can place a trade and receive the next available market price. The same holds true when you decide to sell an ETF.

How Do You Sell Mutual Funds?

No matter how great a mutual fund is, you’ll eventually need to sell some or all of your shares. Since mutual fund shares are sold directly back to the mutual fund company, selling mutual funds is known as “redeeming.”

The process for redeeming shares of a mutual fund is the same as buying: You place a trade for either the specific dollar amount or number of shares you wish to redeem. In return, the fund manager gives you the cash value of your shares based on the next available NAV. And the rest, as they say, is history.

Copyright 2021 U.S. News & World Report

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