What Is a Mutual Fund?
A mutual fund is an investment vehicle that pools money from investors with similar investment goals to invest in different asset types. Professional money managers use the money to purchase securities to help achieve the fund’s objectives.
The type of mutual funds an individual might purchase depends on their financial goals, risk tolerance, and time horizon. Investing in these funds can support long-term portfolio diversification and lower risk.
Types of Mutual Funds
Mutual funds typically fall under one of the following categories:
Equity (stock) funds: Equity or stock funds are invested in corporate stock of publicly traded companies. These funds can be classified by company size, industry or sector type, potential growth and value, or other factors.
Bond funds: Bond funds are made up of debt instruments that the government or a corporation sells to raise capital. These funds often carry less risk than stock funds and might have less growth potential.
Money market funds: Money market funds invest in cash or cash-equivalent short-term debt from entities such as corporations or the government. The funds are generally considered low-risk investments.
Hybrid funds: Hybrid funds are comprised of at least two or more asset classes, typically a blend of stocks and bonds. A popular hybrid fund is a balanced fund, which typically invests 60% in stocks and 40% in bonds.
Benefits of Mutual Funds
The benefits of investing in mutual funds include:
Diversification: Purchasing mutual funds provides exposure to stocks and bonds in diverse industries. Diversification reduces risk, since one asset performing poorly can be offset by other assets performing well.
Low barrier to entry: Investors can make smaller contributions that can grow over time.
Professional money management: Mutual funds have diversification and ongoing supervision of their holdings, potentially increasing their returns.
Liquidity: Mutual funds are easily sold.
Risks of Mutual Funds
The risks of investing in mutual funds include:
Potential for loss: Mutual funds can lose principal and fluctuate in value.
Costs: Mutual funds can have upfront or back-end sales charges and high management fees.
Tax implications: Dividends and interest payments typically are considered taxable income, even if reinvested.
Basics of Investing in Mutual Funds
Understanding a mutual fund’s performance is essential for investing. Review the fund’s prospectus to ensure the investment objective and risk level meet your investment goals.
Consider the following factors before investing in a mutual fund:
Past Performance
Although historical performance is not a guarantee of future results, understanding a mutual fund’s previous performance provides valuable context, including its performance during market highs and lows.
Turnover Ratio
The turnover ratio is the number of times a fund’s assets are traded in a year compared to its total asset value. Because of the costs accrued when buying and selling stocks, mutual funds with higher turnover ratios tend to be more expensive than those with lower turnover ratios
Total Return
Total return is a measure of a fund's performance that includes reinvested dividends and capital appreciation. Because the listings might be calculated for different time periods, such as weekly, check the durations being used.
Operating Fees, Sales Charges, and Other Expenses
Investors might pay annual operating fees, shareholder fees, and other fees and penalties for a mutual fund:
Expense ratio: Also known as the annual operating fee, the expense ratio can be calculated by dividing a mutual fund’s annual expenses by its average net assets. The higher the expense ratio, the higher the cost.
Shareholder fees or sales charges: These commissions and redemption fees are also known as either a front-end load or a back-end load, depending on whether they are assessed at the time of purchase or the time of sale.
Early withdrawal charges: Early withdrawal charges might be incurred when withdrawing or selling the holding early.
Questions to Ask Before Investing in Mutual Funds
Consider asking a licensed financial professional the following questions before deciding to invest in mutual funds:
How might mutual funds fit into my investment portfolio and support my personal goals?
What types of mutual funds might be appropriate for me?
What other investment solutions should I consider?
*This information is for educational purposes only.
Do you invest or plan to invest in mutual funds? Let me know in the comments!
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