Investment funds are financial tools that effectively allow investors to pool their resources to buy into a collection of securities. It’s relatively common and easy for beginning investors to dip their toes in the market with investment funds for a variety of reasons.
But there are many types of investment funds, and the purported benefits of a specific fund may not be the right choice for each investor. With that in mind, it’s generally a good idea to have a deeper understanding of investment funds before buying into one.
What Is an Investment Fund?
Broadly speaking, an investment fund is a collection of funds from different people that is used to buy financial securities. Investors get the advantages of investing as a group (purchasing power) and own a portion, or percentage of their investments equal to the money they have contributed.
There are different types of investment funds, including mutual funds, exchange-traded funds (ETFs), and hedge funds. Typically, these funds are managed by a professional investment manager who allocates investors’ money based on the type of fund and the fund’s goal. For this service, investors are generally charged a small fee that is a percentage of their investment amount.
What Is a Mutual Fund?
Mutual funds are a popular type of investment fund for a reason: they are an easy way to purchase diversified assets — from stocks and bonds to short-term debt — in one transaction.
One of the fundamental ideas that led to the creation of mutual funds was to provide individual investors with access to investments that might be more difficult to obtain or manage on their own. A retail investor with $1,000 probably wouldn’t be able to effectively recreate a portfolio that tracks the S&P 500, let alone rebalance it quarterly.
But thanks to the creation of mutual funds, investors can pool all of their money together into a collective fund to invest in the same markets by choosing from custom-packaged funds with specific focuses and inexpensive share prices.
Different Types of Mutual Funds
There are a number of different types of mutual funds, each of which offer something distinct to the investor.
Equity Funds
Also known as stock funds, equity funds are a type of mutual fund that invests in a specific asset class, principally in stocks. Equity fund managers seek to outperform the S&P 500 benchmark by actively investing in growth stocks and undervalued companies that may provide higher returns over a period of time than the fund’s benchmark.
Equity funds have higher potential returns but are also subject to higher volatility as well. It’s common for equity funds to be actively managed and thus typically charge higher operating fees. Funds with higher stock allocations are more popular with younger investors as they allow for growth potential over time.
While equity is a specific asset investment by itself, some mutual funds focus on more precise criteria:
Fund Size (Market Cap)
Some funds only include companies with a defined market cap (market value). Different tiers of company sizes can perform differently in different economic conditions and companies can be viewed as more or less risky based on their market cap. Fund sizes are categorized by the following:
• Large-Cap (Over $10 billion)
• Mid-Cap ($2 billion to $10 billion)
• Small-Cap ($300 million to $2 billion)
Industry/Sector
Funds that focus specifically on a single industry or sector such as technology, healthcare, energy, travel, and more. Owning shares in different sector mutual funds provides portfolio diversity and can potentially enhance returns if a particular industry experiences a tailwind.
Growth vs Value
Some funds differ in their investment style, focusing on either value or growth. Growth stocks are expected to provide outsized returns, whereas value stocks are considered to be undervalued.
International/Emerging Markets
Domestic stocks are not the only equity investment options, as some funds focus exclusively on international and emerging markets. International and emerging market funds provide geographic diversity — exposure to companies operating in different countries and countries with growing markets.
Bond Funds
Like stock mutual funds, bond funds are a pool of investor funds that are invested in short- or -long-term bonds from issuers such as the U.S. government, government agencies, corporations, and other specialized securities. Bond funds are a common type of fixed-income mutual funds where investors are paid a fixed amount on their initial investment.
Seeing as how bonds are frequently thought of as a safer investment than stocks and offer less growth, bond funds are popular among investors who are looking to preserve their wealth as opposed to aggressively growing it.
Index Funds
This type of fund is constructed to track or match the makeup and performance of a financial market index such as the S&P 500. They provide broad market exposure, low operating expenses, and relatively low portfolio turnover. Unlike equity funds, an index fund’s holdings only change when the underlying index does.
Index fund investing has exploded in popularity in recent years due to its low costs, passive approach, and abundance of options to pick from. Investors may choose from a number of indices that focus on different sectors such as the S&P 500 (financial and consumer), Nasdaq 100 (technology), Russell 2000 (small-cap), and international indices.
Balanced Funds
Also known as asset allocation funds, these hybrid funds are a combination of investments in equity and fixed-income with a fixed ratio, such as 80% stocks and20% bonds. Balanced funds offer diversity to different asset classes and consequently trade some growth potential in an attempt to mitigate some risk.
One example of a balanced fund is a target-date retirement fund which automatically rebalances the investments from higher-risk stocks to lower-risk bonds as the fund approaches the target retirement date.
Money Market Fund
This low-risk, fixed-income mutual fund invests in short-term, high-quality debt from federal, state, or local governments, or U.S. corporations. Assets commonly held by money market funds include U.S. Treasuries and Certificates of Deposit. These funds are usually among the lowest-risk types of investments.
Alternative Funds
For those seeking true portfolio diversity beyond traditional stocks and bonds, it may be worth considering alternative investment funds. Alternative funds focus on other specific markets, such as real estate, commodities, private equity, or others.
These asset classes generally make up a small percentage of one’s portfolio, if at all, and serve as a hedge to heavier-weighted allocations to traditional sectors. Rather than investing in companies of a particular index or market cap, alternative funds may be composed of shares of natural gas drilling companies, real estate investment trusts (REITs), intellectual property rights, or more.
Benefits of a Investing in Mutual Funds
While no two funds are the same, mutual funds are a popular choice for investors of all types for a variety of reasons.
Diversification
Mutual funds serve as a sort of investment basket that contains many different assets, some with the same general focus and others with multiple focuses. Rather than being all-in on one particular investment, mutual funds offer diversity across multiple investments.
This allows investors to cast a wider net and benefit when one or multiple of their basket investments performs well. Conversely, when one investment in a mutual fund does poorly, the loss may be mitigated by also having other investments that are performing comparatively well. Some types of funds offer greater diversification across different asset classes, such as stocks and bonds.
Performance
Mutual funds that aim to track indices or focus on growth stocks typically yield similar market performance compared to the benchmark index. This is more or less the same goal of a buy-and-hold strategy, as fund performance often, but not always, mirrors the tracked index.
Low Maintenance
Mutual funds are relatively easy to use and require little to no maintenance. They allow investing in multiple asset classes through one investment vehicle without having the investor sift through and make individual decisions. All of these decisions are usually provided by an active fund manager whose responsibility is to provide profitable returns for investors based on the fund’s general focus or target.
Mutual funds also provide a degree of functionality. One convenient feature is the ability to set a passive monthly investment amount and to automatically reinvest dividends. Many mutual funds pay investors dividends on an annual, quarterly, or even monthly basis. Dividends are calculated based on the underlying companies’ earnings and distributed to the fund which then passes them along to fund investors. Another feature of mutual funds is the ability to reinvest dividends, thus compounding both mutual fund holdings and dividends in perpetuity.
High Liquidity
Mutual funds are transacted frequently. Investors are able to easily buy or redeem mutual fund shares daily at the market open. Shares in funds tend to be relatively affordable as they typically have a low net asset value (NAV), allowing even novice investors to buy shares with a low starting amount. Compare this to ETFs which can be transacted repeatedly at any time during market hours, but the price can rise to seemingly out-of-reach levels for a beginner.
Active Management
Mutual funds are usually actively-managed by a professional fund manager who’s responsible for operating the fund, whether it be to allocate investor money, rebalance the fund’s investments, or distribute dividends to investors.
While mutual funds tend to have relatively low fees, investors are subject to an annual fee, also known as an also known as an expense ratio, that is calculated as a percentage of each individual’s holdings in the fund and automatically paid to the fund manager for their services. Fund fees vary, so in some cases it may be helpful to compare funds based fees before investing.
Can I Lose Money in a Mutual Fund?
With investing, there is no such thing as a sure thing. So, yes, you can lose money in a mutual fund. It is possible to lose all of your money in a mutual fund if the securities in the fund drop in value.
That said, some mutual funds aim to be conservative and designed to offer slow but incremental gains over time. As always, it’s prudent to research exactly what’s contained in a particular mutual fund before investing any capital. Ultimately, it’s every investor’s responsibility to determine their own risk tolerance and investing strategy that meets their personal needs.
The Takeaway
Investment funds are a practical and beginner-friendly way to start investing in financial markets. Even with beginner knowledge concerning what is a mutual investment fund, mutual funds have the propensity to provide a hands-off and a potentially low-cost way to start building wealth. But again, your mileage may vary, as not all funds are alike.
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