A mutual fund is a collection of different types of investments, like stocks and bonds, that are held within a portfolio. If you buy into a mutual fund you’re buying into the “pie” that makes up the portfolio and you get a piece of it.
Each mutual fund is a prorated share of all the investments that make up the fund’s “pie”. A big misconception is that you actually own the stocks, bonds, etc. that the fund invests in – that’s not true. You own a share of the mutual fund that then purchases those stocks and other investments with the money they have. The money is accumulated from all investors.
A mutual fund is a good way to invest if you’re unsure of the stock market or don’t have time to monitor finance news, companies, and more. If you’re interested to learn more about how to invest in mutual funds, our ultimate guide to mutual funds will cover all the most important things you need to know.
What is a Mutual Fund?
A mutual fund is a legal entity, or an investment company. If you buy a share of a mutual fund you’re essentially buying an ownership stake in the mutual fund company. A common term used for mutual fund holders is shareholders.
The mutual fund company is responsible for pooling all of the investors’ money to hire a fund manager who will invest based on the fund’s objective. For example, an objective may be to generate income for the shareholders or another objective may be to seek capital appreciation.
Essentially the objective is what the fund is trying to achieve and the strategy is how they are going to achieve that objective. This is the sole purpose of a mutual fund.
Types of Mutual Funds
There are thousands of mutual funds out there with different types of investments that you can tap into. The massive amount of mutual funds can make it pretty difficult to find ones you like or want to invest in.
A great place to start with mutual funds is the fundamentals. There are six fundamental categories based on what they invest in:
- Stock Funds: These funds primarily invest into only stocks.
- Bond Funds: These funds primarily invest in bonds and other fixed income sources.
- Asset Allocation Funds: These invest in both stocks and bonds and try to balance each.
- Money Market Funds: These funds typically invest in liquid, short-term bonds with the goal to give investors an alternative to cash.
- Commodity Funds: These funds invest in commodity-related companies like energy and mining.
- Alternative Funds: They invest outside of the stock-bond spectrum and often use more complex trading strategies.
Most funds will fall into the above categories but may specialize a bit further depending on the type of category. For example, a Stock Fund will target stocks but the fund itself may be more interested in investing in technology related stocks versus other industries.
Two other options that aren’t really a category but more of a type are balanced funds and target-date funds. A balanced fund tries to balance out the type of investments they invest in to give the portfolio a decent ratio of stocks vs bonds. A target-date fund will change its allocation depending on how close they are to the target date. A target-date fund will be more aggressive in the beginning and gradually get more conservative with their investments as it nears a specific date. A target-date fund is great for someone who doesn’t know or want to spend too much time researching.
Mutual Fund Benefits
A mutual fund has a few key benefits:
- Low Minimum Investment Requirements
- Professional Management
A mutual fund may invest in hundreds, or even thousands, of stocks and bonds. The diversification of assets allows it to reduce risk. Most mutual funds have lower investments requirements with some as low as $1,000 or even $2,500. These can be an early retirement investment for many teenagers or college students.
Aside from securing a bit more of your finances, it’s nearly impossible to get the above benefits without having someone manage the mutual fund. By having someone manage the mutual fund it takes nearly all of the work off of the investor. When you buy into a mutual fund there is already a dedicated manager for that fund and the manager will make the decisions on where and how to invest. The type of decisions made depend on if its an active or passive mutual fund.
Passive vs. Active Mutual Funds
Active Mutual Fund: An active mutual fund is when a portfolio manager actively selects which investments to buy and sell with the goal of outperforming a specific benchmark.
Passive Mutual Fund: A passive mutual fund aims to match the benchmark and not outperform it. The sole purpose of this fund is to match the performance of the index. A passive portfolio manager does not actively select stocks or bonds to buy and sell.
If you’re not sure of what type of fund you should dive into, we suggest looking for a passive mutual fund. These funds are very hands off and often incur less fees and overall cost with a very similar return.
Mutual Fund Fees
A mutual fund can have a few different fees associated with it but the most common fee is the expense ratio.
An expense ratio is the annual fee that a fund will charge a shareholder. It is expressed as a percentage of the assets under management and is deducted from the fund each year to cover costs. This fee pays for the operational costs of managing a fund. It’s dedicated straight from the fund which means shareholders will get lower returns.
The average expense ratio for a mutual fund is 0.55%. It can be higher and some have fees around 2% but most sit below 1%.
Two other fees you should be aware of are sales load charge fees and 12b-1 fees. A sales load charge fee is a fee that gets charged to you whenever you buy or sell. Not all funds have this fee so it is best to find funds that do not charge this fee. The 12b-1 fee is an ongoing fee to pay an advisor or firm for marketing the fund. The 12b-1 fee is capped at 1% but it takes away that 1% from you and depending on how much you have in a mutual fund, it could be a few hundred to several thousand lost.
How Are Mutual Funds Taxed?
A mutual fund can be tricky with taxes. The biggest thing people forget is that any capital gains are required to be distributed to shareholders. If the fund had a good year then you may end up seeing quite a bit of income your way. This can either offset some losses or potentially put you in a new tax bracket and cause you to owe more taxes.
If the capital gains are short-term then you only pay income tax on the distribution. If it was a long-term capital gain then you’ll pay a lower capital gains rate.
If the fund pays a dividend then you’ll have to claim it and pay taxes on them. A dividend is treated as ordinary income and will be taxed as such.
The best way to avoid taxes on the distribution is to put this income into a tax-deferred account, such as a traditional IRA or a 401(k). This is especially good if you don’t plan on using the money any time soon.
How to Choose a Mutual Fund
The type of mutual fund that you choose should depend on why you’re investing and your investment goals. Before you even look at mutual funds you should identify what your goals are and how much time you have until you want to reach that goal.
For example, if you have a shorter time period then you should avoid stocks and invest in other areas. You would want to select a fund that meets that goal.
As soon as you’ve decided upon your goal and time period you’d like to achieve this goal, you should start researching funds. A big mistake many first-time investors make is to only look at the 1-year return rate of a fund and they’ll typically go for the biggest one and hope for the best. This is not the right performance data to look at. You should be looking at a wider range, preferably 10 years. If the fund has consistently increased every year for 10+ years (even at a lower pace) then you know you’ll have a good chance at coming out ahead versus a fund with only a few good years.
You’ll want to target funds that offer the least amount of risk with a consistent year over year profit.
How to Buy Mutual Funds
In order to buy into mutual funds you’ll have to find a fund manager. It’s not like stocks where you can just go pick up Robinhood or sign up for TD Ameritrade. The process is still very similar to when you purchase stocks but the fund manager is the one who receives your request and processes it.
A mutual fund can be bought on a per-share basis or with a specified dollar amount. For example, you can either buy 100 shares or buy $1,000 of a fund. Most fund managers are willing to sell fractional shares which allows people to get into the fund at a much lower cost.
Exchange-Traded Funds vs. Mutual Funds
In terms of structure, an ETF and Mutual Funds are very similar. They are both investments companies that pool together shareholders money to buy a collection of securities. The key difference between the two is how they are traded and prices.
ETFs trade like stocks which means investors can buy or sell ETFs on the exchange throughout the trading day instead of purchasing shares through a fund manager. As a result, ETFs can’t be bought by specified dollar amounts and will require full share purchases. This is primarily due to the fluctuation in price that happens depending on investor demand.
The advantage to ETFs is that you do not have to wait until the market closes for the fund manager to calculate the NAV (net asset value) so you know how much you make when you sell.
Selling Mutual Funds
Eventually you will want to sell some or all of your shares in a mutual fund. Since the mutual fund shares are sold directly back to the mutual fund company, selling mutual funds is known as “redeeming”.
The process of redeeming shares is the same as buying. You will place a trade for a specific dollar amount or total share amount you want to redeem. The fund manager will give you the cash value of your shares based on the next available NAV. If the market is already open, you won’t get the next available NAV until the market closes.