Mutual funds can make excellent long-term investments, as they can provide a diverse portfolio of stocks, bonds, or other assets with just a single investment. Here's a primer on how mutual funds work, the different types of mutual funds available, and how to get started with mutual fund investing.
The basic idea of a mutual fund
The short description is that a mutual fund is a pool of money from many people that is then invested professionally and according to the fund's objectives.
There are mutual funds for a variety of investments, such as stocks, bonds, and commodities. Within each of these broad categories are plenty of subcategories. If you want to invest in a bond mutual fund, you can find examples that invest in long-term Treasuries, tax-free municipals, high-grade corporate bonds, inflation-protected bonds, and many more.
Active vs. passive mutual funds
Whatever their investment focus, all mutual funds can be divided into two broad categories based on their management structure -- active and passive.
An actively managed mutual fund employs a fund manager (or managers) who decides how to invest the fund's money in line with its objectives. For example, an actively managed large-cap stock fund's manager would be responsible for deciding which stocks the fund's capital should be invested in and how much should be allocated to each.
On the other hand, a passively managed mutual fund simply tracks a stock index, which is why these are commonly referred to as "index funds." For example, an S&P 500 mutual fund invests in the 500 stocks that make up that index, and in the same proportions as they are each weighted in the index.
You may think that actively managed funds have an edge. After all, shouldn't highly knowledgeable managers be able to do better than the overall stock market? That isn't always the case. In fact, for reasons I'll discuss later on, actively managed mutual funds fail to beat their benchmark index the majority of the time.
Benefits of mutual fund investing
For many people, mutual funds can be a great way to invest, especially beginning investors, but they do have a few drawbacks. Here's a rundown of the pros and cons of mutual fund investing.
There are two main benefits of mutual fund investing.
- Simplification -- Mutual funds eliminate the challenges that come with picking individual stocks or bonds, as they have professional managers who do the work for you.
- Diversification -- With investment commissions, it can be difficult to efficiently create a truly diversified portfolio of stocks without thousands of dollars to invest. On the other hand, a mutual fund allows you to spread your money over many stocks or bonds.
Mutual fund fees and expenses
The major drawback of investing in mutual funds as opposed to individual stocks is the cost. Investing in mutual funds is not free -- there are fees and expenses to consider. In fact, over time, the majority of mutual funds have underperformed their benchmark indices, and the fees they charge are a big reason.
All mutual funds have fees, which are listed as the expense ratio. An expense ratio represents a fund's annual fees as a percentage of its assets. In other words, a 1% expense ratio implies that you'll pay $100 annually for every $10,000 in assets you have invested in the fund. These fees vary considerably and can be quite high, especially for actively managed funds.
You may see two different expense ratios listed -- gross and net. The gross expense ratio is the "official" expense ratio of the fund, while the net expense ratio may reflect certain temporary adjustments or discounts.
Some mutual funds have additional expenses known as sales charges, or loads. These are commissions paid to advisors, brokers, and financial planners. A front-end sales charge is paid upfront when you invest, while a back-end sales charge is paid when you eventually sell your shares. Many investors will only consider no-load funds to avoid these potentially expensive costs.
How do you invest in a mutual fund?
You can invest in a mutual fund through an online brokerage, such as TD Ameritrade or E*Trade, to name a couple examples. Alternatively, you can invest in mutual funds directly through the companies that offer them, such as Vanguard or Fidelity. Many funds have minimum initial investments (generally in the $500 to $5,000 range), and some companies will waive this requirement if you commit to making periodic investments.
Mutual funds can be excellent investments for individuals who aren't comfortable picking individual stocks, or who simply don't want to spend the time and effort necessary to create a properly diversified portfolio of stocks and bonds.