I’ve been investing in mutual funds since I got my first job out of college. It’s worth noting that I’ve actually known what a "mutual fund" really is and how it works for far less time than that.
Here is what you need to know about mutual funds so you can feel confident about adding them to your investment portfolio!
Mutual Funds: Defined
I often turn to Investopedia for help understanding all things financial.
- Investopedia's definition of a mutual fund: A mutual fund is a collection of stocks and/or bonds. You can think of a mutual fund as a company that brings together a group of people and invests their money in stocks, bonds and other securities. Each investor owns shares, which represent a portion of the holdings of the fund.
How Mutual Funds Earn
Mutual funds basically earn money in three ways. Typically, you can choose how to receive your earned income (via a check called a "distribution," or through adding the new earnings back into the principle as a "reinvestment").
- Distribution earnings: If your mutual fund is made up of bonds, you’ll earn a distribution from accrued interest. If your mutual fund is made up of stocks, you’ll earn a distribution from dividends.
- Capital gains earnings: If the fund manager chooses to sell securities and realizes a profit on the sale, these earnings are called capital gains.
- Share profits: If the fund manager doesn't sell securities that have increased in price, but then you decide to sell your shares of the mutual fund, the profit you receive from the sale is called share profits.
4 Main types of mutual funds
There are three major categories of mutual funds you can choose between. Within these four major types exist smaller groups of specialty funds, including those indexed to the market, those that only invest in international securities and other types.
- Money market mutual fund: These funds are composed of mostly short-term treasury bonds. This is the lowest-risk type of mutual fund.
- Fixed-income mutual fund: These funds are composed of a variety of bonds, including corporate and government bonds. The risk is medium with this type of mutual fund.
- Balanced mutual fund: These funds include both bonds and stocks. They earn their name from their efforts to perfectly balance risk against return.
- Equity mutual fund: These funds are composed of a variety of stocks. This is the highest-risk type of mutual fund.
Why invest in a mutual fund?
Here are the major pros to choosing a mutual fund as part of your portfolio:
- Diversification: Mutual funds possibly do the best job out of all the various investment types of balancing risk with return ("diversification") by selecting a variety of different investments.
- An expert fund manager: A mutual fund might have one or several fund managers who all work together to ensure the fund consistently yields the highest possible rate of return for shareholders.
- Lower overall fees: Because a mutual fund typically transacts large trades at any one time, each shareholder's portion of those fees will be lower.
- Highly liquid: There is no restriction on when you can buy or sell your mutual fund shares.
- It is simple: There is no art to buying into a mutual fund. In most cases, you can buy them through your employer, broker or bank.
Understanding mutual fund fees
The biggest downside to investing in a mutual fund is also the biggest upside—the professional fund management. There are three main categories of fees any mutual fund incurs—each of which is passed through to the shareholders.
- Fund managers' salaries: The fund manager(s) are paid based on how well the fund performs (averaging 0.5-1% of the total fund value).
- Administrative fees: Transaction fees, postage fees and any other fees.
- 12B-1 fees: 12B-1 fees are essentially marketing fees.
Note: Depending on the type of mutual fund you buy into, you can expect fees to run you anywhere from 0.2-2% of your investment value.
How to save when investing in mutual funds
The best way to save when beginning to invest in mutual funds is to look for funds that bear the designation "no load." This means you do not have to pay mandatory fees to buy into the fund (either on the front end as a flat fee or on the back end as a percentage).
However, there is no guarantee that a no-load fee will outperform the other types of funds—ultimately this is where the risk of mutual fund investing shows itself. If a mutual fund is posting high returns, it may be worth paying a bit more in fees.
As well, you want to look at the Net Asset Value (NAV)—essentially the "price per share" to buy into the mutual fund. You want to look at the NAV of any fund you’re considering buying into and then compare it against others as you’re doing your research.
Your ultimate goal is to select the fund with the best NAV and the lowest fees!
Two great research resources you can trust:
- Morningstar: http://www.morningstar.com/Cover/Funds.aspx
- Mutual Fund Education Alliance: http://mfea.com
How to purchase a mutual fund
Many no-load funds are available for purchase through the fund manager directly. Other types of funds can readily be purchased through a bank, a broker or even an insurance agent.