To some investors (new and old), picking individual securities to invest in and manage can be risky. Enter mutual funds. With pros like additional security and lower risk, mutual funds are one of the hottest investment options out there. But before you jump in the collective pool, you need to know the cons. So, what actually is a mutual fund? How does it work? Is it right for you?
What Is a Mutual Fund?
A mutual fund is a collective pool of money provided by individuals for money managers to invest in various securities (like stocks and bonds). Because it's collective, every shareholder or investor benefits and loses in equal portion - and the expenses of the mutual fund are shared in the expense ratio. And, because the funds are diversified between stocks, bonds and other securities, they are usually lower risk than individual stocks or bonds.
Mutual funds are operated by money managers, who create portfolios for investment with the pool of money, and often have different kinds of investment goals. Some managers, like fixed-income managers, focus on generating low-risk, high pay-off investments for their funds, while long-term growth managers try to beat the Nasdaq or S&P 500 during the fiscal year.
Shares in a mutual fund (also called mutual fund units) are typically bought at the fund's current net asset value (NAV, or sometimes NAVPS) per share. This figure is determined by dividing the total value of all the securities in the fund by the number of outstanding shares.
Mutual funds are actually investments that kind of work like buying stock in companies. Investors buy shares into the mutual fund, which in turn gives them a claim to the fund's assets (the profits from the investments the mutual fund makes). So, the value of the mutual fund is contingent on the value of its portfolio (or collection of securities).
How Does a Mutual Fund Work?
When you invest in a mutual fund, a manager takes the public funds contributed into the fund pool and invests them in various securities, such as stocks and bonds.
The manager is typically hired by a board of directors and is often a part-owner in the fund itself. Fund managers will occasionally hire analysts to help them make investment decisions. Most funds will have an accountant who calculates the net asset value of the fund each day, which will determine the share price of the fund. Most funds also have compliance officers who keep up-to-date on regulations.
Once investors buy into a mutual fund, their money is used by the fund manager to invest in various securities with certain goals for risk and return in mind - like long-term growth or fixed-income. Some funds may be riskier than others, but in general, the structure of a mutual fund keeps risks relatively low.
Additionally, mutual funds only trade once daily and are often part of a 401(k) or an individual retirement account, IRA.
Types of Mutual Funds
As mentioned earlier, there are different kinds of funds with different goals. The four principle kinds of funds (in terms of structure) are open-end funds, closed-end funds, load funds and no-load funds.
Most mutual funds are open-end funds, which means they can keep adding shares and don't have a fixed amount. So, they're bought and sold on demand. With open-end funds, the fund can continue issuing shares based on the NAV, or redeem shares when investors decide to sell.
Open-end funds tend to be much more liquid of an investment, and have lower investment minimums than other mutual funds. The fund's NAV is priced once a day, as opposed to the continual fluctuation throughout the day expected of other securities. This is because open-end funds aren't traded on major stock exchanges.exchanges
A closed-end fund has a set number of shares that are traded among investors, just like stocks.
And like stocks (and unlike open-end funds), they are traded on an exchange and their prices change according to supply and demand. These mutual funds issue their shares through an initial public offering, or IPO, and trade on the open market, just like a company does.
Because their shares are subject to supply and demand, closed-ended mutual funds are often at a discount to their NAV. So, the major upside to closed-end funds is that they often offer phenomenal premiums (sometimes up to 50% premium).
Some mutual funds are considered load funds - meaning the investor has to pay a sales commission in addition to the NAV on the fund's shares when they invest.
When you pay the commission depends on the shares that you own. Class A shares are front-end load funds, which means you pay the fee upfront when you buy the shares. Class B shares have what is known as a "back end load," where the fee is paid after you sell your shares. Class C shares are also known as "level load shares," and a fee is paid yearly.
If a mutual fund does not charge a load, it's (astoundingly) called a no-load fund. For this reason, no-load funds are often higher-return for investors because there aren't as many fees tied to investing. But don't be confused by the name: no-load funds may not have a load fee, but there can still be fees investors will have to pay.
How to Invest in a Mutual Fund
The most important thing before you invest in a mutual fund is to know your personal goals. What level of risk are you comfortable with? Have you researched the past performance of the mutual fund? What kind of fees are you willing to pay?
Typically, funds are either equity funds (investment in stocks), fixed income funds (investment in bonds), or money markets (kind of like cash).
One of the main factors you will have to consider is the minimum threshold for investing in the mutual fund - different funds have different investment minimums.
To invest, you can typically buy into a mutual fund through a mutual fund company, bank, or brokerage firm (similar to stocks). Additionally, you will need to decide if you want to invest in a load or no-load fund (which means you will either be paying commission or not). But regardless of if you invest in a load or no-load fund, you'll still be paying some fees, so be sure to factor that in when deciding.
And it is really simple to invest in a mutual fund - simply delineate the amount of money you'd like to invest over the phone, online, or in person (as there are so many options these days).
Online brokers generally have the largest selection of mutual funds, and often offer more diverse selections. However, you will have to open an individual retirement account (IRA) or brokerage account, or you can use your 401K account provided by your employer.
Still, there are several expenses to account for - namely, transaction fees accumulated when investing in a mutual fund, early redemption fees if you wish to sell a fund in the first 60 to 90 days, and expense ratios (from the fund) that are a percentage of your investment.
You can make money off of your mutual fund either by selling it for more than you paid for it (earning capital gains), or through a variety of distributions like dividends or interest that can be paid out throughout your investment. However, most mutual funds will reinvest dividends for you unless you specify otherwise.
Pros and Cons of Mutual Funds
Perhaps the biggest pro of mutual funds is they are managed by someone other than the individual investor - putting the tough decisions in a professional's hands. Because managing the fund is their only job, the fund manager is able to devote much more time and expertise into wisely allocating your funds than you could yourself.
Additionally, because mutual funds often offer diverse portfolios with a collective pool of money, the individual risk to each investor is reduced, making mutual funds fairly low-risk, (hopefully) high-reward.
However, mutual funds also come with fees - in the form of annual operating fees and shareholder fees. Annual operating fees generally are 1%-3% of the annual funds under management, while shareholder fees are like commissions paid by shareholders when they buy or sell funds.
Additionally, an obvious con to mutual funds is that you don't always have control of which stocks you're investing in - and, for the savvy or active trader, this may cause some frustration, especially if your fund starts losing.
Mutual Funds vs. ETFs: What's the Difference?
What is the difference between these two investment options you've likely heard about? ETFs are hot on the market as an alternative to mutual funds - and have several pros compared to their counterpart.
While mutual funds are typically broken down into open- or closed-end funds, exchange-traded funds, or ETFs, can come in three main structures: exchange-traded open-end index mutual funds, exchange-traded unit investment trust (UIT), or exchange-traded grantor trust.
Exchange-traded open-end index mutual funds reinvest dividends on the day of receipt and are also paid quarterly to shareholders as cash. Exchange-traded unit investment trusts, on the other hand, don't immediately reinvest dividends, but still pay quarterly cash dividends ( (QQQ - Get Report) is one of these). And, an exchange-traded grantor trust operates more like a traditional stock in that the investor actually owns shares in the companies that the ETF invests in - with voting rights to boot.
Additionally, ETFs have several noticeable differences to mutual funds. For starters, ETFs are typically composed of a certain index or sector (like Nasdaq or S&P 500), whereas mutual funds are at the discretion of the manager.
ETFs also trade all day long, compared to the once-daily trade of mutual funds after the market closes around 4:00 p.m. each day. And, due to less overhead costs, ETFs typically don't have investment minimums (while mutual funds do), so that makes them cheaper for some investors.
Because ETFs are generally passive in nature, the internal expenses are greatly reduced. This may be a selling factor for investors who want to keep fees down.
ETFs are generally better for active investors (since you can trade them all day), but it is important to know the differences to determine which is best for you.
Check out the best ETFs here.
Indexed vs. Active Management Funds
The big difference between indexed and active management is that the latter, well, is actively managed by fund managers, whereas indexed funds track an index like S&P 500.
In active funds, the fund managers will actively make trades of stocks and bonds to try to maximize returns for their investors. But indexed funds (which many ETFs are) simply track an index.
Both ETFs and mutual funds can be actively managed - but it comes at a price tag for all that analysis and expertise. For this reason, indexed funds can have fees as low as 0.10%, but actively managed funds' fees can span much higher.
Still, it is important not to just jump at the lowest-cost option when it comes to funds. Weigh your options and ensure you are fully informed before opting for either active or indexed funds - because there definitely is a plus to having professionals analyzing the best investment options for you.
Best Mutual Funds
There are now more than 10,000 mutual funds out there, according to Forbes. So, lots of options.
Some of the biggest mutual funds include Fidelity Investments (FIS - Get Report) , Oppenheimer Funds (OPY - Get Report) and the Vanguard Group (VOO - Get Report) . However, some of the best mutual fund brokers are E-Trade (ETFC - Get Report) , TD Ameritrade (AMTD - Get Report) , Ally Invest (ALLY - Get Report) and Charles Schwab (SCHW - Get Report) .
Make sure to do your homework beforehand and see what is realistic for you.