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There are many reasons to invest in mutual funds, including the most popular one: diversification. When an investor has their money in mutual funds, it helps spread out the portfolio among many different assets, which protects the portfolio from volatility in the market.
Mutual funds are recommended for all investors. There are four main types of mutual funds. In this article, we cover all the basics so you can decide which type of mutual fund is right for you.
What Is a Mutual Fund?
A mutual fund is a pooled investment that lets investors put money in many different securities with one single investment. Investing in a mutual fund allows an individual to add hundreds, or even thousands, of assets to a portfolio through a single investment. This is known as diversification, which protects investments. Experts agree that diversification is the key to building wealth.
“At the end of the day, the benefit of a mutual fund or any pooled investment is it allows you to access a diversified set of companies and sectors for lower costs.” said Jill Schlesinger, CFP and the host of the Jill on Money podcast.
How Do Mutual Funds Work?
Mutual funds pool money from many investors to buy the securities that make up the fund. The fund’s manager chooses investments based on the fund’s goal, which could include buying and selling securities or simply tracking the performance of a particular index.
Active vs. passive funds
Mutual funds come in two types: active and passive.
A passive fund tracks an established index like the S&P 500. There really isn’t much cost involved to the investor, because the fund just purchases all of the assets within that particular index. The S&P 500 includes the 500 largest companies on the stock market.
These are also known as index funds, and they have become increasingly popular in recent decades But they aren’t the only type of mutual fund. Many mutual funds are actively managed, meaning a fund manager buys and sells securities to build a portfolio that attempts to beat the market. Experts agree passive funds are the way to go.
What Different Types of Mutual Funds Are There?
There are several types of mutual funds, and they’re classified by the type of assets they hold.
“The mutual fund’s investment goal determines the types of securities it purchases,” says Hutch Ashoo, the founder and CEO of Pillar Wealth Management, a financial firm. “A mutual fund can specialize in one or more types of investments. A fund might, for example, invest primarily in government bonds, large-company equities, or stocks from specific nations.”
When choosing a mutual fund to invest in, consider your investment goals and choose a fund that aligns with your goals. Choosing low cost mutual funds can help jump start your investment portfolio and get you on track for retirement.
The four most common types of mutual funds are:
- Equity funds invest in corporate stocks. They might track a particular stock index, like the S&P 500. They may also specialize in a particular type of stocks, such as growth or income stocks. This is the most popular type of mutual fund.
- Bond funds, also known as fixed-income funds, invest in bonds and other debt instruments. Some may seek to sample the overall bond market, while others specialize in a particular type of bonds, such as corporate bonds, government bonds, or junk bonds.
- Money market funds have the lowest risk of any type of mutual fund. Legally, they can only invest in short-term, high-quality debt instruments.
- Target date funds, also referred to as balanced funds or lifecycle funds, invest in a variety of equity and debt instruments as a way of providing a balanced portfolio that decreases in risk through someone’s lifetime.
What Are Mutual Fund Fees?
When investors purchase a mutual fund, they might be charged an expense ratio, or fee, for that fund. An expense ratio is expressed as a percentage. The higher the expense ratio, the more it’ll eat into an investor’s returns. Before investing, check the fees. Anything under .2% is considered a low fee; anything over 1% is high.
The other fee associated with mutual funds is a shareholder fee.
Shareholder fees are often incurred when an investor either buys or sells their shares in the fund. They can include sales loads, redemption fees, and commissions. Not all mutual funds require shareholder fees, as some are considered no-load funds and allow investors to buy and sell without paying commission.
Classes of Mutual Fund Shares
Mutual fund shares can come in several different classes. Each of the different classes of a particular mutual fund invests in the same underlying securities and has the same investment objectives. However, the classes have different features and expenses, which can impact their ultimate performance. Here are the different ones:
Class A shares charge most of their fees upfront in the form of a front-end sales load. In exchange, they have the lowest annual expenses. Class A shares are best suited for long-term investors because if you hold the investment long enough, then the reduced expense ratios make up for the larger upfront cost.
Class B shares don’t have a front-end sales load. As a result, they’re cheaper to purchase up front, especially for large investments. But the annual fees on these shares are typically higher than Class A shares, and they also have a back-end sales load, which is a charge you’ll pay when you sell your shares.
Class C shares might have a small front-end or back-end sales load, but the primary cost comes from a higher expense ratio. Class C shares are ideal for those who plan to hold their shares for a shorter period of time, since the sales load is lower.
Not all mutual fund shares fall into one of these categories. In fact, many mutual funds that you’ll run across as an investor are considered no-load funds. They don’t charge a front-end or back-end sales load. Your only cost is your annual expense ratio. These types of mutual funds are the ones investors typically go with.
Advantages/Disadvantages of Mutual Funds
- Diversification: Building a well-diversified portfolio is one of the cornerstones of long-term investment. Mutual funds allow investors to diversify their portfolios not only within an asset class but also across asset classes, with just a few holdings.
- Low fees: Certain types of mutual funds have very low fees, which allows you to keep more of your investment returns. For example, many index mutual funds have expense ratios of less than 0.05%.
- Professional management: For many investors, the idea of choosing their own investments can feel overwhelming. But in the case of active mutual funds, a fund manager takes care of that for you.
- Dividend reinvestment: When you earn dividends and other sources of income from your mutual fund investment, you can automatically reinvest them in the fund. As a result, your investment continues to grow even if you aren’t actively investing more.
- Higher fees on active funds: While passively-managed mutual funds can have incredibly low fees, active funds tend to be more expensive. The higher management fee accounts for the fact that the fund manager plays a more hands-on role in choosing investments.
- No intraday trading: Unlike exchange-traded funds (ETFs), which are a similar pooled investment, mutual funds don’t allow for intraday trading. Instead, trades only take place at the end of the trading day, meaning you have less control over the price.
- Limited control: When you invest in a mutual fund, a fund manager chooses the assets on your behalf. In the case of a passive fund, you know exactly what assets are within the fund. But with an active fund, the fund manager can frequently buy and sell assets, and you wouldn’t necessarily know.
What is a mutual fund and how does it work?
A mutual fund is a pooled investment where a fund manager takes the money of many investors and uses it to buy stocks, bonds, and other assets. They allow investors to achieve a well-diversified portfolio through a single investment.
How do you make money from a mutual fund?
Mutual fund investors can generally make money in three ways: dividends on the equities it owes, interest on the bonds it owns, and capital gains when the investment increases in value.
Can you lose money in a mutual fund?
As with most investments, you risk losing money in a mutual fund if the investment declines in value. The more diversified a mutual fund is, the less likely you will lose your entire investment. Remember that investing in mutual funds is a long-term game, so don’t worry about short-term falls.
Are mutual funds safer than stocks?
Mutual funds provide diversification, which helps reduce your risk of loss. As a result, experts view them as safer investments than individual stocks.