Mutual funds are a type of investment product that comes in various shapes and sizes and that can be used by investors in both retirement and non-retirement accounts. If you're thinking of investing in mutual funds but don't know where to start or simply want a refresher course, we've got you covered. Read on to learn more about mutual funds, their benefits, and the pitfalls associated with them.
Mutual funds are one of the most commonly used vehicles for investing because they allow people to pool together money to obtain various benefits, including:
- Increased diversification
- Lower transaction costs
- Simpler record-keeping
- Professional management
Here's how mutual funds work.
An individual selects a mutual fund and then contributes money up front or makes regular investments into it. Those investments are combined with money invested by other people, then a manager or a team of managers employed by the mutual fund company selects investments matching the mutual fund's specific objective and buys and sells those investments as necessary.
All mutual funds are required to report their objectives, risks, and costs to their investors via a prospectus and annual reports and to disclose their holdings to investors regularly. Because mutual funds are commonly used by investors, their prices, returns, holdings, and other key information is readily available online or through investment professionals, who may be compensated for selling them.
Types of mutual funds
If you're investing in mutual funds through a workplace retirement plan, there will likely be a more limited menu of mutual fund choices, but if you're investing on your own, the options available to you are seemingly endless.
Investor choices include diversified mutual funds that invest across hundreds of companies, bonds, or similar investments and concentrated mutual funds that can own fewer investments, or that invest in a specific subset of a particular market, such as a mutual fund investing solely in healthcare companies.
Investors can also choose mutual funds that invest in large or small companies, growing or dividend- paying companies, government bonds or state bonds, or any other number of investment options.
Additionally, mutual funds can either be actively managed, which means that investments can change frequently or passively managed, which means that investments rarely change. An example of a passively managed mutual fund is a fund that mirrors an index, such as the S&P 500.
Because mutual funds are available for just about any investment objective, finding a mutual fund that matches your investment goals isn't hard, but that doesn't mean that mutual funds don't have risks and drawbacks that investors need to consider before investing, including the risk of losing money.
In addition to losing money, some other common disadvantages of mutual funds include:
- Expenses and fees that can be high
- Returns that can fluctuate significantly from year to year
- Transactions that can increase taxable income
- A lack of control over what you own
Investing in mutual funds can be done directly with a mutual fund company or through an intermediary such as a financial planner or a broker.
Although mutual funds may appear to be similar with identical objectives, the underlying investments owned can still vary substantially and performance may differ significantly and that means investors need to take the time to consider each fund individually.
Also, just because two funds appear to have identical mandates doesn't mean that the costs associated with those two funds will be similar. For that reason, make sure to compare expense ratios for mutual funds before investing in them, too.
Investors should also know that mutual funds can be offered in various classes of shares and that those classes can have very different fees and expenses. For example, B class mutual fund shares are sold with penalties if money is withdrawn too soon after investing in them.
And another thing
One of the biggest mistakes made by investors is failing to shop around for mutual funds. Mutual fund fees and expenses can run 2% annually or higher, and back-end fees associated with B class shares can exceed 5%. Because of these expenses and fees, mutual funds are an attractive option for financial planners to sell and that means it's smart to do your own research before investing in one that is recommended to you.
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