Table of Contents
Mutual funds are a type of investment vehicle that combine numerous types of securities in one basket. They’re similar to exchange-traded funds, or ETFs, in that way, but there are some key differences. Mutual funds can provide investors with an accessible and turnkey way to build a portfolio with a mix of assets, often with a manager watching over the fund.
Key Points
• Mutual funds pool money from multiple investors to invest in a variety of securities, providing a degree of diversification.
• These funds typically allow individuals to get started with investing using smaller amounts of money.
• Shares in mutual funds represent ownership in all the fund’s underlying assets.
• Actively managed funds seek to outperform a benchmark, while passively managed funds aim to track an index.
• Mutual funds typically have higher fees and less liquidity compared to ETFs.
The ABCs of Mutual Funds
Mutual funds are funds, or a basket of different securities, that are packaged together and sold, in shares or fractional shares, to investors.
Mutual funds were designed for people to get started investing with smaller amounts of money. You can think of them as suitcases filled with different types of securities, such as stocks and bonds. Buying even one share of the fund immediately invests you in all the individual securities the fund holds.
The primary benefit of mutual funds is a degree of portfolio diversification. Say you invest in a mutual fund that holds stocks of every company in the S&P 500. If one company in the S&P 500 goes bankrupt, your fund might lose some value, but you probably won’t lose everything. But if your whole investment was in that one company’s stock, you’d lose all or most of your money.
How Mutual Funds Work
A mutual fund itself is actually a company that pools investors’ resources and invests it on their behalf. They create a fund of many different investment types, and manage it on behalf of the group of investors.
Mutual funds can be actively or passively managed. Passively managed funds attempt to track an index, such as the Russell 2000 (an index of 2,000 small-cap U.S. companies). In other words, if one company leaves the index and another one joins, the fund sells and buys those company’s stocks accordingly. The risk and return of these funds is very similar to the index.
Actively managed mutual funds attempt to beat the performance of an index and have a professional mutual fund manager. The idea is that with careful investment selection, they will get higher returns than the index.
Different Types of Mutual Funds
There are numerous types of mutual funds that investors can choose to invest in.
Breaking Down Various Mutual Fund Types
Mutual funds can invest in stocks, bonds, real estate, commodities, and more. There are tens of thousands of mutual funds that cover almost every investing strategy you can imagine. Those can include asset class funds, sector funds, or target date funds, among many others.
Asset Class Funds
Asset classes are groups of similar assets that share similar risks, such as stocks, bonds, cash, or real estate. Some funds specialize in a particular type of investment or asset class — for example, large-cap growth stocks or high-yield bonds. These mutual funds assume that you or your adviser will choose the strategic mix of funds that’s right for you.
Sector or Industry Funds
Some funds will attempt to represent all or most of the stocks in a particular sector or industry. What’s the difference between a sector and an industry? Sectors are broader than industries — for example, oil is an industry, but energy is a sector that also includes coal, gas, wind, and solar companies. The stocks in each industry or sector share similar characteristics and risks.
Target Date Funds
A target date fund will provide you with a mix of asset classes (for example, 20% bonds and 80% stocks), and investors choose them with a particular date and goal in mind, usually retirement. These funds shift to less risky investments as the target year approaches.
Target-date funds are intended to be a simple, low-cost solution to retirement saving. They can be a good choice for a 401(k) investment if you don’t have the time or expertise to pick funds.
đź’ˇ Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.
The Financial Mechanics of Mutual Funds
As mentioned, mutual funds pool money from a group of investors and invest it for them in various securities. That seems simple enough — but figuring out how to price shares is a bit more involved.
The Pricing Puzzle: Net Asset Value Explained
Mutual funds are companies, and investors purchase shares of the company. Share prices of mutual funds are equivalent to its per share net asset value, or NAV (not including potential fees). NAV corresponds to the net value of all the fund’s assets, with liabilities subtracted. Then, the number is divided by the number of shares outstanding.
In effect, investors can calculate share prices using the NAV formula if they wish.
Fee Structures: Costs Associated with Mutual Fund Investing
There are also costs associated with mutual funds. All mutual funds have some expenses, but they can vary a lot from one fund to another. It’s important to understand them, because fund expenses can have a big impact on your returns over time.
Another consideration with actively managed funds is that they typically cost more because funds are paying people who make investment decisions, and they are making more trades, which have transaction costs. As such, you may want to look out for operating expenses or transaction fees.
You won’t get a bill, but your returns on the fund will be reduced by the fund’s expenses. Some brokerage firms also charge commission for buying mutual funds.
The Pros and Cons of Investing in Mutual Funds
Like all investments, mutual funds have pros and cons that investors should consider.
Potential Benefits of Diversification and Professional Management
The two biggest potential advantages of mutual funds are likely the built-in diversification that they offer investors, and in many cases, professional management. The diversification element may allow some investors to take a “set it and forget it” approach to their portfolio management, and some may find confidence knowing that professional fund managers are steering the ship.
Considering the Risks: No Guarantees and Potential for High Costs
Cons include the fact that there’s no guarantee in terms of returns (there never are when investing!), and the costs associated with mutual funds. As noted, mutual funds may incur additional costs compared to other investment types, depending on the individual fund. That may turn some investors off.
Taxes and Cash Drag: The Other Side of Mutual Funds
Taxes are another potential consideration, as investors will need to pay capital gains taxes on mutual fund payouts throughout the year. And cash drag (or performance drag), which refers to the difference between the return on an investment that has no costs associated with it and an investment that has costs, such as trading costs, can be another thing for investors to think about.
Mutual Fund Investments and You
How can you determine if mutual funds are right for your strategy or portfolio? It may require some consideration of your goals, time horizon, and risk tolerance.
Are Mutual Funds Right for Your Portfolio?
There’s no way to say definitively that a certain investment or investment type, like mutual funds, are “right” for any given investor. But in a general sense, mutual funds may be a choice to consider if you’re a new or young investor, and looking to add some out-of-the-box investments to your portfolio. Again, mutual funds are typically already diversified to a degree, and are often managed by professionals.
Can You Cash Out Anytime? Understanding Liquidity
Mutual funds are not as liquid as stocks or other investments, but they are fairly liquid. That’s to say that if you want to cash out or sell your mutual fund holdings, a prospective trade will only execute once per day — after the stock markets close at 4pm ET. Conversely, stocks can trade any time during market hours.
Mutual Funds Compared to ETFs
Mutual funds are, in many ways, similar to other types of investments, like ETFs.
Mutual Funds vs ETFs: A Comparative Analysis
Mutual funds have been around in the U.S. in 1924, but exchange-traded funds, or ETFs, are relatively new, having debuted in the U.S. in the early 1990s Traditional (old-school) mutual funds are issued by the fund sponsor when you buy them and redeemed when you sell them.
They are priced once a day, after the market closes, at the value of all the underlying securities in the fund, minus liabilities, divided by the number of fund shares — again, their net asset value (NAV).
Exchange Traded Funds (ETFs) trade on stock exchanges throughout the day. You buy them from and sell them to another investor — just like a stock.
Since the assets in the fund are constantly changing value throughout the day, and the fund price is set by market supply and demand, it might trade a little higher or lower than its NAV at different points in the day, but ETFs generally track their NAV closely. Both traditional funds and ETFs can be actively or passively managed.
ETFs have two potential advantages — liquidity and cost. Even though you may pay a commission for buying or selling them, just like a stock, they generally have lower expenses.
Since they can be bought or sold whenever the market is open, you don’t have to wait until the end of the day to buy or sell. This liquidity can be a big advantage on days when the market is way up or way down.
Understanding Fund Classes and What They Mean for Your Investment
There are some mutual funds that offer classes of shares, or different types of shares (similar to some stocks). The different classes of shares tend to correlate to the types of fees or expenses associated with them. Investors may find Class A, Class B, and Class C shares on the market for certain funds, for example.
Class A shares tend to charge fees up front and have lower ongoing expenses, which may be attractive to long-term investors. Class B shares may have high exit fees and expense ratios. Class C shares tend to have mid-level expense ratios and small exit fees, and are often popular with the typical investor.
Getting Started with Mutual Funds
If you think mutual fund investing may be an option for your strategy, getting started can be relatively simple.
Steps to Your First Mutual Fund Investment
The first thing to do if you’re looking to invest in mutual funds is to sit down and do some homework. As discussed, there are myriad mutual funds out there, and they’re all different. You’ll want to pay close attention to what each fund offers, the costs associated with it, and the risks, too.
If you’ve found a mutual fund that you think is a good fit for your portfolio, you could choose a brokerage or online platform that will allow you to buy shares of a given fund, or otherwise have an account that you can trade with, such as a retirement account.
From there, it’s more or less about placing an order and executing the trade. And, after that, it’s about managing and rebalancing your portfolio every so often.
Working With Financial Advisors: Finding Guidance in Mutual Fund Investing
As with all investments, if you feel that you could use some guidance with mutual fund investing, you could reach out to a financial professional. Financial advisors should be able to help you figure out which funds might be suitable, describe their fees and risks, and help guide you in making a selection that could put you on track to reaching your financial goals.
The Takeaway
Mutual funds are companies that pool investors’ money, and then invest it in numerous types of securities on their behalf. Investors can purchase or invest in shares of mutual funds and add them to their portfolios. Mutual funds can be useful to new or beginner investors, as they offer a degree of built-in diversification, and often, active management.
Mutual funds may have higher costs than other investments, though, which is something investors should consider. Further, there are thousands of mutual funds on the market, which may be overwhelming to some. If you’re interested in investing in mutual funds, it may be a good idea to speak with a financial professional for guidance.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
FAQ
How do you make money in mutual funds?
An investor may make money in mutual funds through capital gains and dividends when (and if) the fund grows in value. You could also make money by selling the shares of your mutual funds for more than you originally paid for them. However, making money in mutual funds is not guaranteed, and you could potentially lose your investment, as well.
What is the downside of mutual funds?
A downside of mutual funds is the cost involved — they typically have higher costs than other common types of investments, such as index funds and ETFs. Another downside is the potential risk of poor management. If a mutual fund is actively managed, and the management makes poor decisions, that could affect an investor’s returns.
What are some different types of mutual funds?
Different types of mutual funds include asset class funds, which are funds that specialize in a particular asset class or type of investment; target-date funds that have a mix of asset classes with a particular end date or goal in mind; and sector or industry funds that reflect the stocks in a particular industry or sector.
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