How Mutual Funds Work And How To Invest In Them

Mutual funds are investment behemoths—accounting for close to 20% of the stock market. This is more than government retirement funds, more than pension funds, and more than international investors. Mutual funds purchase both indexes and specialized sectors, as well as obtain shares across a vast market spectrum. They also purchase bonds and other securities—they may even mix investment types within a single fund.  

Having a mutual fund to your portfolio is a tried-and-tested way to increase your assets over time—no wonder 46% of all households in the US owned mutual funds in 2019. Mutual funds provide investors with automatic diversification—you can have a stake in multiple industries or companies without having to pick individual stocks. Funds are also professionally managed, so you won’t spend time keeping up with the daily proceedings in the stock market.

The financial sages behind MoneyWizard have put together this guide to help take your doubts off the dizzying world of mutual funds. Let’s go!

What is a Mutual Fund?

Mutual funds are SEC-registered (Securities and Exchange Commission) investment companies that pool money from different investors and invest the money in bonds, a mix of stocks, other asset classes, or a combination of all three. The combined securities owned by the mutual fund make up its portfolio—which is typically managed by an SEC-registered investment adviser.

The price of a mutual fund—also referred to as the net asset value (NAV)—is obtained from the total value of the securities held in its portfolio divided by the total fund’s outstanding shares. Each share represents your proportionate ownership of the fund’s portfolio. The price of the mutual fund fluctuates depending on the value of securities held by the fund at the close of each business day.

How Mutual Funds Work

A mutual fund is a type of investment fund—a basket of investments like bonds, stocks, or other funds. So, when you buy a mutual fund, you’re simply pooling your money with many other investors. Contrary to other types of investment funds, mutual funds are technically open-ended, meaning that the fund issues new shares or units as more people invest.

Investors don’t own the securities in which the fund invests but rather shares in the mutual fund. These shares are usually purchased via investment professionals like brokers or directly from the fund. The law requires that mutual funds price their shares on each business day. This typically happens after the close of trading on the major US exchanges.

With actively managed funds, the decision to purchase and sell securities is made by the professional portfolio managers, supported by a team of researchers. The portfolio manager’s objective is to identify investment opportunities that will help the fund outperform its benchmark—which is usually a widely followed index like the S&P 500.

The easiest way to tell how a fund manager is performing is looking at the fund’s returns relative to this benchmark. However, you should bear in mind that past performance isn’t a reliable indicator of future performance. Don’t be dazzled by short-term returns, instead assess its 3– and 5-year returns. You must also remember that mutual funds aren’t insured or guaranteed by the FDIC (Federal Deposit Insurance Corporation)—even if you buy the fund through a bank, and it carries the bank’s name. You may lose all your money if the fund suffers a hit.

Types of Mutual Funds

Mutual funds fall into different categories, as highlighted below.

Money Market Funds

A money market fund has some relatively low risks compared to other mutual funds. Money market funds are restricted to specific high-quality, short-term investments issued by corporations, the U.S. Government, and state governments. Retail and government money market funds try to maintain a stable NAV of $1 per share, but this may fall below $1 if the fund’s investments underperform.

Other money market funds usually have a floating NAV—it fluctuates along with the changes in the market-based value of their portfolio securities. Although money market funds and income funds pay dividends, they’ve historically had lower returns than stock or bond funds. 

Bond Funds

A bond fund primarily invests in bonds or other variations of debt securities. It generally has higher risks than a money market fund, mainly because they pursue strategies geared toward producing higher yields. Contrary to money market funds, the SEC’s rules don’t restrict bond funds to short-term or high-quality investments. The availability of many different types of bonds causes bond funds to vary dramatically in their rewards and risks.

Stock Funds

Stock funds invest mainly in stocks or equities. And while their value may rise and fall quickly over the short term, stocks have historically proven to be better performers over the long term compared to investments like government bonds, corporate bonds, municipal bonds, and treasury securities.

Equity funds are, however, prone to investment risks like market risk, which creates the greatest potential danger for stock fund investors. Stock prices also fluctuate for multiple reasons—like the demand for particular services or products or the overall strength of the economy.

Balanced Funds

Balanced funds invest in bonds and stocks and sometimes money market instruments, all in an attempt to minimize risk while providing income and capital appreciation. 

Index Funds

Index funds track the performance of various stock indices, like the S&P 500. These funds require less professional management since they own all the securities of an index rather than a subset.

Target Date Funds

Target-date funds comprise a mix of bonds, stocks, and other investments to help you accommodate more risks when you’re younger. As you near retirement, the funds become more conservative and take lower risk options. They are a great option if you want to take the guesswork out of saving for retirement.

What Costs Come with a Mutual Fund?

Mutual funds come with costs that can reduce your return on investment. Mutual funds pass along these costs to investors by imposing fees that are broadly classified as either shareholder fees or operating expenses. Shareholder fees are charged in connection with transactions like buying, selling, or exchanging shares while operating expenses are ongoing fund costs.

A mutual fund’s fee table will include the following:

• Sales load (charge) on purchases. This fee is charged by some mutual funds when you buy shares, also referred to as front-end load. The fee is usually paid to the broker that sells the fund’s shares. In context, a sales load could be compared to a commission you pay when you purchase a security from a broker. Front-end loads eat into your investment. Sometimes, however, mutual funds offer no-load options, which doesn’t carry any commission or sales charge.

• Purchase fee. You may pay a purchase fee when you buy shares. Contrary to the front-end load, the purchase fee isn’t a broker fee—it’s paid into fund assets. Mutual funds impose this fee to cover some of the costs associated with the purchase. 

• Deferred sales charge. Mutual funds impose a deferred sales charge when you redeem or sell your shares, also referred to as a back-end load. This fee is paid to the broker that sells the fund’s shares. 

• Redemption fee. Some funds will charge you a redemption fee when you sell or redeem your shares within a specific period of buying the mutual fund shares. Redemption fees are not paid to the broker but into the fund assets. 

• Management fees. Management fees are paid out of fund assets to the fund’s adviser for professional portfolio management.

Pros and Cons of Mutual Funds

Mutual funds come with their fair share of benefits and drawbacks, as we shall look at below.

Advantages of Mutual Funds

• Professional management. When you invest in a mutual fund, you’ll enjoy the benefit of having a professional manager review your portfolio on an ongoing basis. Portfolio managers have the expertise and resources to research companies and analyze vast market information before making an investment decision.
• Diversification. Since mutual funds invest in a large basket of securities, you have access to opportunities in multiple sectors and industries. Diversification will help reduce your portfolio’s exposure to risk.
• Liquidity and convenience. Mutual funds let you sell or buy shares once a day—usually after the close of the trading day, and at the fund’s NAV.
• Dividend payments. Income earned from interest on bonds or dividends on stock is usually paid out to shareholders, less any expenses.
• Capital gains distribution. The price of securities in a fund may increase, so it reports a capital gain when it sells a security whose price has increased. Funds usually distribute these capital gains to the investors at the end of each year.

Disadvantages of Mutual Funds

• Fees can be high. Mutual fund investors must pay annual fees, sales charges, management fees, and other expenses that could eat into their investment returns. You may also pay taxes on the capital gains distribution you receive.
• Lack of control. Mutual fund investors have no direct influence on the securities that are included in a fund’s portfolio.

Differences with ETFs

While mutual funds and ETFs share some similarities, considering their differences will help you choose which investment vehicle works best for your investment strategy.

Trading Method

A huge difference between mutual funds and ETFs lies in how they are traded. Exchange traded funds (ETFs) usually trade during the day and are listed on an exchange. Mutual funds—whether index or actively managed funds—can only be sold and bought once a day, usually after the market’s close. As a result, ETFs can provide more flexibility in reacting to market news quickly.

Management

Mutual funds and ETFs can have either a passive or active management structure. However, most mutual funds are actively managed by professionals who seek to outperform the market. Most ETFs are passively managed since they track the performance of an underlying index. Indexed mutual funds may have a passive management structure since they mirror market indices.

Cost

Since mutual funds are actively managed, they usually incur costs that ETFs don’t—you’re paying for investment-picking expertise. This cost is called the expense ratio—the share of your assets that the fund takes as compensation for managing your money—often expressed as a percentage. The average expense ratio for actively managed mutual funds is 1.09%, compared to 0.57% for ETFs.

Investment Minimum

Most traditional mutual funds need a minimum initial investment, which may range from $500 to $3,000 depending on the fund. You can purchase and sell ETF shares at the posted market price—no investment minimum required.

Tax Consequences

When portfolio managers sell securities at a profit, the proceeds are distributed to fund owners, thus creating a possible exposure to capital gains tax each year. However, this won’t be a problem for mutual fund investments that are held in a 401(k). An ETF makeup doesn’t generate capital gains distributions to the fund owners, therefore avoiding tax exposure.

Transparency

Most mutual funds disclose their holdings on a quarterly basis, whereas investors can view their ETF’s holdings at any time they want.

Conclusion

Generally, most mutual funds are designed for investors who’re eyeing long-term growth potential. And while their values can fluctuate, it isn’t to the extent of investments like individual stocks. Some key points to guide your research on different mutual funds include:

• Understand what the fund is created to do. Each mutual fund is created with specific investment objectives, so take the time to review the Fund Fact Sheet to get an overview. The prospectus can also provide more information about the fund, its investment strategies, and other legal details.
• Costs. You should have a comprehensive understanding of the fees and costs associated with the mutual fund. The two main costs incurred by an investor are the management expense ratio and sales/load charges.
• Net Asset Value (NAV). Since mutual funds are a basket of securities, valuing the fund price may be challenging. Luckily, the net asset value can help you determine the price of a mutual fund—which is essentially a fund’s total equity. The NAV is also used as a price for transacting units in the fund, so when you buy or sell shares, you’re doing so at the price of the NAV.

Frequently Asked Questions

How Much Risk Is Involved with Investing in Mutual Funds?

The amount of risk involved with investing in mutual funds often depends on what the fund invests in. Stocks are typically riskier than bonds, so stock funds are riskier than bond funds. Besides, some specialty funds focus on certain types of investments, like emerging markets to generate higher returns. This makes such funds a greater risk in the event of a larger drop in value.

Some common risks associated with bond funds include:

• Credit risk. Issuers whose bonds are owned by the fund fail to settle their debts.
• Interest rate risk. The risk that the bonds’ market value will go down when interest rates increase.
• Prepayment risk. The likelihood that a bond may be paid off early, typically before maturity.
• Market risk. The value of a fund’s investments may decline due to effects on the entire market.
• Liquidity risk. The mutual fund can’t sell an investment whose value is declining since there are no buyers

Remember, variety will give you a better shot at mitigating risks. A fund with a more diversified portfolio reduces your exposure to risk.

Are Mutual Funds Safe?

Mutual funds are a safe investment vehicle, and this is attributed to their diversification abilities. As a result, you don’t have to worry about your portfolio taking a hit because of an underperforming stock. Despite the instant diversification, mutual funds don’t guarantee a certain return after investing in the stock market—but they can be a great option if you want to consistently invest for the long term.

What is the Minimum Investment for a Mutual Fund?

Most mutual fund companies require a certain amount as the initial investment, but the amount may vary from as little as $300 up into several thousand dollars. While this gives you a way to dip a toe into the water instead of getting in over your head, it can also be a barrier to individual investors.

Are Mutual Funds Safer Than Stocks?

Mutual funds are safer than stocks because they provide diversification through exposure to a wide range of asset classes. Individual stocks carry more risk than owning shares in a mutual fund.

Do You Have to Pay Taxes On Mutual Funds?

Generally, you’ll have to pay tax on the money you make on a mutual fund. Dividends, interests, and capital gains have different tax implications, and this will impact investment returns. Bear in mind that all capital gain distributions are subject to tax in the year you receive them, whether they’re in cash or reinvested on your behalf.

However, you won’t pay income tax on any money you make from a mutual fund held in an individual retirement account.