What Are Mutual Funds?
Mutual funds are an investment that can help you minimize risk and diversify your portfolio. Here’s how they work and what the pros and cons of investing in them are.
When it comes to investing, we’ve undoubtedly all heard the phrase, “Don’t put all your eggs in one basket.” But how do you know where to diversify your hard-earned money? One option is a mutual fund, a large portfolio comprised of multiple investors that you can buy shares of.
Mutual funds allow you to diversify your portfolio because you’re buying into a fund that owns several types of securities. This article will explain, in detail, how they work, the different types, pros and cons, and how you can get started. After reading, you’ll have a better grasp on whether investing in one is right for you, as well as how to begin.
How Mutual Funds Work
Mutual funds are professionally managed portfolios that are made up of several investors. They buy and hold several types of securities, such as stocks, bonds, short-term debt, and more. These are often beneficial for investors because they come with less risk than individual stocks and bonds, as well as greater diversification.
As mentioned earlier, professional managers run mutual funds. This may be an individual or an entire team. You can see their buying strategy in your fund’s prospectus, a document that outlines the investing philosophies they’ll follow. Any research, buying, or selling is up to them, rather than you. The simplicity of such a situation is another reason why people choose to invest.
When you purchase shares of a particular mutual fund, you own shares of the fund itself, not the assets it owns. With each share, you’re entitled to a piece of the income it creates. For example, if a stock that’s part of the share pays a dividend, you’ll get a cut equal to what you own. To buy shares, you can do so via online brokers or by working with a professional, such as a financial advisor.
Keep in mind that, as you buy shares of a mutual fund, you may need to place a minimum investment of $500 to $5,000. And, in the case of working with a brokerage firm, you may need to pay a commission on the transaction. This is a percentage of the amount you invest in the fund.
Risk Still Exists
While you might see claims that mutual funds are free of risk, this simply isn’t true. Any investment, including this type, comes with the possibility that you will lose money. Often, they’ll go up or down with the market. Buying or selling at the wrong time could cause you to lose money. As always, use caution before deciding to jump in with an opportunity.
Types of Mutual Funds
There are several types of mutual funds to choose from. A key difference between each one is the securities it buys. How the portfolio is run is also a distinguishing factor. For instance, an index fund buys based on market performance, whereas a sector fund only focuses on a specific industry.
Here are the most common types you’ll find, as well as how they work:
- Balanced funds contain both stocks and bonds in one. Income and growth potential come from dividends. You may also see people refer to these as hybrid funds.
- Bond (or fixed income) funds invest mainly in bonds, such as ones that are government, corporate, and municipal.
- Equity funds consist of mostly, if not entirely, stocks or equities from US or foreign companies. Typically, they are categories based on the type of companies invested in. These include small-cap, mid-cap, and large-cap funds.
- Index funds track a specific market index such as the S&P 500 or the Dow Jones Industrial Average. They don’t try to beat the market, opting to match its performance by investing in the same kind of stocks in the index. Often, index funds are referred to as passively managed mutual funds.
- International funds buy securities from all over the world. Some focus on a specific region, while others invest in assets from various countries.
- Money market funds focus mainly on short-term and low-risk investments like treasury bills or commercial paper. They’re popular for their stability and offer capital preservation and liquidity.
- Sector funds emphasize a specific industry such as technology, healthcare, energy, or real estate. These can be riskier and volatile because they’re not as diversified.
- Specialty funds invest in a specific class of assets or strategies including commodities, real estate investment trusts (REITs), socially responsible investments (SRIs), or private equity.
- Target date funds base their investments on a specific timeline. They tend to begin with riskier, higher-yielding investments early in the cycle, then shift towards more conservative holdings as the target date approaches. If you were to invest in one of these, you would select one with a timeline that aligns with your goals.
Pros and Cons
Like any other investment, mutual funds have both benefits and disadvantages to consider. For instance, they’re typically low-risk and highly liquid, but earnings take time and there are fees you must pay. Below, we fully dive into the pros and cons you should review before investing in them:
- Great way to diversify. Since mutual funds tend to invest in various types of securities, you have a great opportunity to diversify your portfolio.
- They’re often highly liquid. At any time, you can sell your shares for their current value.
- They’re professionally run. Professional managers run mutual funds. They perform in-depth research and market analysis, so you don’t have to.
- Easy to invest in. To invest in a mutual fund, all you need to do is buy shares either online or through a broker. And they typically come at a low cost, which lowers the barrier to entry even more.
- You’re able to reinvest dividends. When you earn income from dividends, you can automatically reinvest it to buy more shares.
- You’ll have to pay fees. When you invest in a mutual fund, you’re subject to annual management fees.
- You’re at the mercy of a fund manager. While it’s mostly reassuring to know a pro is handling everything for you, you also have less control. Poor managerial decisions may occur, and if they do, they’ll affect your bottom line.
- Risk. Often, funds go up or down with the market, so your shares may depreciate over time, causing you to lose money.
- Distributions are taxable. Any time a security within a mutual fund is sold, you’re subject to either capital gains or regular income taxes. Which rate you pay is dependent on the duration that the investment was under the fund’s ownership.
How to Get Started
Investing in mutual funds is a relatively simple process. However, there’s a bit of research that goes along with the process. Here are the steps you should follow to invest in this type of asset:
1. Determine How You’re Going to Buy and Sell
There are a couple of ways to buy shares of a mutual fund. You can do so by opening an online brokerage account or within a retirement account, such as a Roth IRA. Online financial services providers, such as Vanguard and Fidelity, allow you to easily open accounts and begin trading.
You can also invest by working with a professional, such as a credentialed financial advisor (investment and wealth managers, financial planners, etc.) or a broker. The former typically is a fiduciary, who puts your best interest ahead of their own. Brokers, on the other hand, may not be (especially if they earn a commission).
2. Select Which Fund(s) You’d Like to Invest In
This is likely the most challenging part of the process. It’ll be up to you to decide which types of funds to allocate your money to. You’ll need to weigh the benefits and downsides of each to make an informed decision. This includes understanding how a prospective one works, its outlook, and any other vital details, such as fees.
Luckily, you don’t have to go it alone when it comes to research. Having a financial advisor on your side can help you figure out which mutual funds work best for you. If you need help finding one, you can use a matching tool. After filling out a short quiz about your situation and goals, it’ll match you with vetted professionals in your area.
3. Monitor Results and Make Necessary Adjustments
A key part of investing is keeping track of your returns. It’s a good idea to pay attention to the income you’re receiving from any mutual funds you own shares of. Not only will you understand whether holding on to them is worth it, but you’ll also be aware of any taxes you’ll need to pay down the road. It may be smart to consult with a tax planner to ensure no surprises later on.
How Much It Costs to Invest in Them
A mutual fund’s cost is made up of a few different factors. Unlike a stock, you’ll be paying the market price plus any requisite fees. Here’s a brief rundown:
- Market price. To buy a mutual fund, you’ll need to pay the market price. This varies depending on current economic conditions and the type you’re targeting. As an example, the Fidelity® 500 Index Fund (FXAIX) is currently trading at $154.10 per share.
- Management fees. You’ll need to pay an annual management fee or “expense ratio.” This is typically 0.5% to 2.5% of the assets the fund owns.
- Sales charges. Buying from a “load” fund means you’ll need to pay a sales charge or commission in addition to the market price. However, there are “no-load” funds that don’t come with any extra charges.
- Taxes. While not part of the initial cost, you should consider the fact that you’ll need to pay income or capital gains taxes if you’re using a brokerage account. Keep in mind that if you use a Roth IRA to buy shares, the IRS won’t ever tax you on the income (as long as you keep it in the account until you’re 59.5 years old).
Frequently Asked Questions
Can I cash out my fund?
Yes, you should be able to liquidate your shares at any time. When you do so, you’ll receive an amount equal to their current market value.
How much money should I start with in a mutual fund?
Typically, you’ll need anywhere from $500 to $3,000 to invest in a mutual fund. However, there are no-minimum ones out there. For instance, Fidelity’s Total Market Index Fund (FSKAX) doesn’t require any minimum investment to begin.
Is a Roth IRA a mutual fund?
No, it isn’t. A Roth IRA is a retirement account you can use to buy and sell securities, such as mutual funds. All of the money in the account, including the profit you make, isn’t subject to taxes when you decide to withdraw it. The only catch is that you must be 59.5 years old to do so.
Are hedge and mutual funds the same?
No, the two are not the same. While both are managed portfolios, they have different characteristics. Hedge funds are mainly for high-net-worth investors, and there are limitations on how often they can liquidate assets. They also charge much higher fees. Mutual funds, on the other hand, are available to most people and allow trading whenever the market is open.
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