A mutual fund is a professionally-managed investment vehicle that pools together money from several investors and then purchases a portfolio of stocks and/or bonds. Each investor owns a (very small) portion of the shares in the fund. Some mutual funds are actively-managed, meaning the fund manager actively ensures the fund provides the best returns. Other funds are passively managed, e.g. index funds, and include a portfolio of stocks that will mimic movement of the entire market. Index funds are typically cheaper than actively-managed funds.
Types of Mutual Funds
There are several different kinds of mutual funds. Equity mutual funds invest in stocks while bond mutual funds invest in bonds. Money market mutual funds are invested in money markets like Treasury bills and CDs (not FDIC insured like money market savings accounts). REIT mutual funds are invested in real estate investment trusts, a security that’s invested in real estate and mortgages. Balanced mutual funds are invested in a variety of assets. Sector funds are invested in certain industries, e.g. technology or health. Socially responsible funds are invested in health conscious and environmentally friendly companies. Just about every conceivable asset class or investment philosophy can be represented via mutual funds.
Mutual funds are required to provide a prospectus which details important information about the fund, like the strategies, goals, fees, expenses, and past performance. While the prospectus must be provided after the purchase, you can request to see a copy before you buy so you can decide if you want to invest in that fund. Many funds’ prospectus are available online at the fund’s website or through the SEC’s EDGAR system: http://www.sec.gov/edgar/searchedgar/prospectus.htm.
Earning Money from a Mutual Fund
Investors can earn money from a mutual fund in a few ways. Funds make distributions to investors when the stocks pay dividends, the bonds pay interest, or the fund makes a sale that results in a capital gain. You can also opt to have your dividends reinvested rather than receiving a payout. Investors can also make a profit by selling their shares if the fund shares have increased in price. You may have to pay a capital gains tax on sales and trades made during the year.
Advantages and Disadvantages of a Mutual Fund
Investing in mutual funds lets you own a variety of stocks and bonds cheaper than if you tried to buy direct from the company. It’s also a safer investment since you own several securities and the risk is spread among a large number of holdings. You might suffer some losses, but it’s not likely that you’d lose everything – all the holdings would have to bottom out for that to happen. That’s possible, but extremely unlikely.
While diversification is one of the primary benefits of a mutual fund, there are also drawbacks. If one of the stocks has huge gains, the mutual fund’s overall return may not be affected, especially if the fund has a large variety of holdings.
Since the fund is professionally managed, you can lean on the fund manager’s expertise (and time) rather than trying to manage your own portfolio. Investing in a mutual fund is also cheaper than hiring a manager to invest on your behalf. However, professional management does come at a cost, even when your fund doesn’t make any money. You’re also subject to the fund manager’s investment principles.
Buying a mutual fund rather than several different securities lets you save money on transaction fees, which you have to pay for each purchase. You do have to pay for fund management, but the management cost is spread among all the fund’s investors.
Typical fees for a mutual fund include the management fee, which covers the cost of the fund manager, administrative costs for things like customer service and record keeping, brokerage commissions, and advertising costs. Marketing fees known as 12b-1 fees are common with commission based funds. Mutual fund expenses are represented by the expense ratio, also called the management expense ratio. The expense ratio can be as high as 2%, but high fees don’t necessarily correlate to excellent performance.
Some mutual funds also have an upfront fee, called a load, that you pay to a salesperson or broker who sells the fund. Most experts advise to invest in no load mutual funds, if you’re comfortable overseeing your own investments.
It doesn’t take a lot of money to invest in a mutual fund, and there is a large number that can be invested in directly. It’s easier to compare mutual funds based on the net asset value (NAV) per share, which is the fund’s assets minus its liabilities. That’s the price you’ll pay to purchase shares of the fund. When you’re choosing a mutual fund, you also have to consider the amount of risk you’re willing to accept. Some funds are riskier than others. While big risk can result in big gain, it can also result in big losses.