What Is A Mutual Fund? How They Work And How To Invest For Beginners

Forbes

4 days ago

Many investors achieve their investment goals using just mutual funds because of their breadth of ... More options, relatively low costs and ease of use.
Mutual funds are an accessible investment vehicle which provides average or advanced investors with a wide range of exposure and diversification to a vast swathe of investment options from equities to commodities to bonds. Investors can delve deeper into specific sectors or sub-categories of funds in these categories, choose passive or active funds, and shop for ideal fee structures. In this guide, you'll gain an introduction to mutual funds including their advantages, risks, categories and how to buy your first mutual fund share.
What Is A Mutual Fund?
A mutual fund is an investment vehicle which pools money from investors and invests into securities like stocks and bonds to achieve the funds' objectives whether this is tracking an index or providing diversified exposure to a particular asset class. Mutual funds trade just once per day at the funds' net asset value (NAV) unlike stocks or ETFs which trade during market hours on an exchange. Mutual funds are managed by professional teams and can range from low expense ratio passive funds which track an index to actively managed funds who charge higher minimums and expense ratios as they try to beat a benchmark.
How Do Mutual Funds Work?
Mutual funds are managed by teams who manage the operations of the fund from choosing investments, rebalancing holdings and managing cash flow. As mentioned, when you buy or sell shares in a mutual fund they trade at the end-of-day NAV and aren't actively traded during the day like a stock or ETF. Index funds are a type of mutual fund which just passively tracks an index like the Nasdaq-100 while actively managed funds charge higher fees as they try to beat a benchmark.
Types Of Mutual Funds To Know
There are a number of types of mutual funds distinguished by the assets they invest in and the goal of the fund, like equity funds which invest in stocks, to ESG funds which invest in stocks based on a company's adherence to particular standards.
Equity funds are mutual funds investing in stocks with the goal of appreciating capital. These funds are often distinguished by growth or value focus, by investing in particular sectors of the stock market, or investing in particularly-sized companies. Equity funds are ideal for investors focused on long-term portfolio growth as they're more volatile but usually deliver higher returns than fixed-income funds.
Fixed-income funds pool investor money to buy bonds to deliver ensuing interest from these bonds to investors. These funds can invest in particular types of bonds like government or corporate bonds to provide concentrated exposure to a bond type while diversifying across many bonds or a mix of bond types to provide even greater diversification and reduce risk. Fixed-income funds are commonly invested in by investors who wish to earn more income or reduce volatility in their portfolio if they're heavily invested in riskier assets like stocks.
Money market funds aim to deliver some yield for investors while maintaining a NAV of $1 by investing in Treasury bills or other short-term investments like high-grade commercial paper. These funds are often used in brokerage accounts as a short-term holding place which earns interest before investors invest in other assets.
Target date funds are a useful mutual fund type for investors who wish to invest in a single fund for life which shifts from more growth and equity heavy to more conservative and fixed-income heavy as the investor inches to retirement age. These funds are commonly used by investors who don't wish to manage their own portfolio diversification, particularly in a 401(k) account.
Commodity funds provide exposure to the price moves of specific commodities like gold, oil or a mix of commodities. These funds will invest directly in the commodity, buy commodity futures contracts or by simply owning stocks linked to the commodity. These investments can be useful to diversify a portfolio or hedge against inflation but they still bear risk like price drops for specific commodities like new discovery of oil increasing global supply, and thus dropping oil prices.
ESG, or environmental, social and governance, funds are a popular mutual fund type with socially-conscious investors who wish for their investments to align with their values. These funds will research and evaluate companies for how they align with certain benchmarks like how sustainable they are, how diverse their boards are or how they treat workers.
Benefits Of Investing In Mutual Funds
There are five main benefits of investing in mutual funds from ease of diversification to fast liquidity in case you need to cash out of your position.
A principal benefit of investing in mutual funds is the diversification that one or multiple mutual fund positions can provide. By purchasing a share you can own percentages in hundreds of stocks, helping you diversify and reduce risk in concentration. With ownership of multiple mutual funds dedicated to different asset types, sectors or categories, you can reduce volatility and ensure portfolio diversification.
Another benefit that mutual funds provide is the professional management of mutual funds by investment teams all working to ensure risks are mitigated, investments are well researched and the right trades are executed. This is especially useful for investors who don't have the time or expertise to manage a portfolio of hundreds of stocks and assets themselves.
In addition to diversification and professional management, mutual funds provide a high level of accessibility to the average investor. With as little as $100 in brokerage accounts and IRAs, investors can own shares of hundreds of stocks, and 401(k)s often waive these minimums, making it even easier to get started.
Like many stocks, mutual funds are also highly liquid, allowing investors to sell shares by the end of the business day when the market closes. This daily liquidity makes it easy to close a position if you need to access cash, rebalance your portfolio or invest in a new opportunity in just a day.
When you invest in mutual funds which pay dividends you'll also access the ability to reinvest dividends, which are paid out or other distributions, ensuring you can compound your investment. Many brokerage accounts will offer a Dividend Reinvestment Program (DRIP) which is an often free program where dividends are reinvested without fees, and fractionally if the dividend isn't enough for a full share.
Risks Of Investing In Mutual Funds
While mutual funds are generally considered less risky investments, there are a few risks you should bear in mind before determining if mutual funds in general or specific mutual funds are right for you.
A primary risk of mutual funds, common with securities in general, is the risk of share prices falling based on the assets' lowered value. For example, equity mutual funds will fall when the stock market or a particular sector dips or a commodity fund will fall if that particular commodity's price falls based on some global event. Risk is inherent with most investments so knowing your risk tolerance and balancing your portfolio will help hedge against market risk.
If you choose to invest in an actively-managed fund, know that your fund can outperform a benchmark but it can also underperform due to manager risk. Whether the fund manager loses key personnel or makes a mistake, this can affect the return of your fund.
If your chosen mutual fund is focused on investing in an asset with lower trading volume than say, a major index, like small-cap stocks, the fund may experience lower liquidity in the event of a sell-off, resulting in a lower NAV from sales at unideal prices. While mutual funds are required to follow liquidity management plans, unexpected events can affect NAV negatively.
Interest rate risk is most acutely felt with fixed-income funds when interest rates rise causing fixed payouts from the fixed-income fund to not be a worthwhile investment causing a sell-off. This risk can be mitigated by investing in a mix of bond or fixed-income funds by time horizon so you can ride out dips from interest rate increases.
Costs And Fees To Understand
The main cost of mutual funds are expense ratios which are a percentage of assets that fund managers will charge annually to pay for operating costs, typically under 0.20% for passive funds, but as much as over 1% for actively-managed funds. Two other fees you may run into are load fees which are fees charged when you make an initial investment in some mutual funds and redemption fees which are charged if you cash out a position in certain mutual funds. Finally, other fees may arise with some mutual funds like 12b-1 marketing fees, so it's always crucial to read a fund's prospectus to fully comprehend the true cost of a fund versus potential returns.
How To Invest In A Mutual Fund
Below are the five steps to get started investing in mutual funds from determining your investing intent to placing your order and monitoring your performance.
Laying out your goals will help you determine the right mutual fund type for you. For example, knowing the goals you have in mind as well as knowing your risk tolerance, what your current portfolio mix is, and how long you're investing for will help you figure out whether you need to be more risk-averse with more invested in bond funds or more growth minded with equity funds.
Choosing the right account to invest in your mutual fund will be tied to your investment goals. For example, if you're saving for a home, you should invest through a taxable brokerage account but if you're investing for retirement, you should invest in your 401(k) or IRA. If you're investing for a child's college savings, you should choose a 529 plan and if you're saving for future health costs, invest through your HSA.
Next, research available funds in either the brokerage's research tools or a third-party tool like Yahoo Finance or Morningstar, including how the fund performs against benchmarks, what fees are charged and what the fund's portfolio is made up of. Read through the fund's prospectus to make sure it aligns with your investment objectives and see if there are any better mutual funds available.
Enter the ticker symbol in your brokerage account trading window, select how much you want to invest, and determine whether you want to reinvest dividends or not. Confirm the settlement rules and check that all fees or penalties are as you expected before you submit the trade.
Finally, monitor the performance of your mutual fund by reviewing how it performs quarterly, gauging how it performs against the benchmark, and tracking if there's been any drastic changes in fees. Be confident in your research but assess the performance over the quarters to track any price changes and why they occurred.
Bottom Line
As you've learned, mutual funds are an excellent investment vehicle regardless of your experience, level of capital or asset preference. Many investors have and will achieve their investment goals using just mutual funds because of their breadth of options, relatively low costs and ease of use. With the information in this guide, you're better armed to achieve your investment goals too, whether you choose to get started with passive or actively-managed mutual funds or another investment vehicle of your choosing.
Frequently Asked Questions (FAQs)
Are Mutual Funds Safe?
All investments bear the risk of loss of some or all of your principal investment, but mutual funds are generally considered a safer investment as they offer diversification and are regulated by the SEC.
What Is The Minimum To Invest In A Mutual Fund?
The minimum to invest in mutual funds can range depending on the mutual fund and whether your brokerage account provides fractional investment in mutual funds. If you can fractionally invest, you can pay just $1 to invest, while mutual funds themselves can allow for a minimum investment of up to $100 if they offer low minimums, or $500 to $10,000 if they have a high minimum.
Can I Lose Money In A Mutual Fund?
Yes, you can lose money in a mutual fund as the net asset value (NAV) of these funds can rise and fall depending on the market. Even a bond mutual fund can lose value if interest rates rise, causing a fall in bond prices and the corresponding NAV of the fund.
Are Index Funds Different From Mutual Funds?
Index funds are a type of mutual fund which tracks a particular index like the S&P 500 index. Index funds often charge lower expense ratios and are useful for passive, diversified portfolio construction.