Mutual funds: Definition, types, and how to invest (2024)

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  • A mutual fund is a portfolio of investments that pools money from investors to purchase securities.
  • The majority of mutual funds are professionally managed with the aim to outperform the market.
  • Mutual funds can add value to a portfolio by offering professional management and diversification.

A mutual fund is a type of investment vehicle that pools money from many investors to purchase stocks, bonds, or other securities. Investors who mutually contribute to the fund company become part owners of the fund's portfolio and the income it generates or loses.

You can invest in mutual funds through a broker or investment platform. The best online brokerages offer low minimums, account flexibility, investment tools and resources, and access to human advisors for personalized guidance and advice.

Here's what to know about mutual funds, including how they work, what to watch out for, and how to get started investing in them.

How do mutual funds work?

Generally, mutual funds are actively managed by a fund manager who controls when to buy and sell securities to maximize returns and minimize losses. When you buy a mutual fund, you're buying partial ownership of the fund and its assets, meaning its entire portfolio of investments.

This differs from buying an individual stock, where you buy partial ownership directly in a company and manage any subsequent moves yourself (unless you have a financial manager).

The price of a mutual fund is determined by its net asset value (NAV), which takes all of the portfolio's securities into account. It is found by dividing the total value of the fund's assets (cash and securities) by the number of the fund's outstanding shares.

Since a mutual fund's portfolio consists of many securities that change price throughout the day, the NAV is calculated at the end of the market day. Because of this, mutual funds trade only once per day, after the stock market closes.

Mutual fund fees

You should be aware that mutual funds come with structured fees for active management, which eat into your total profits. A mutual fund will label fees into two main categories:

  • Annual fund operating expenses: A fund's total annual operating expenses include management and transaction fees, which are expressed collectively as the fund's expense ratio. While relatively small, expense ratios can significantly affect a fund's return, especially over time.
  • Shareholder fees: A fund can also come with shareholder fees, which cover commissions regarding buying and selling the fund. Most mutual funds will have a sales charge called a "load," which can be a flat fee or a commission, and occur when you purchase or sell your shares back to the fund.

If you're in the market for a mutual fund, its fees are an important factor to consider. You can find all associated fees outlined in detail in the fund's prospectus.

How to make money investing in mutual funds

You can make money on mutual funds in a few different ways:

  • Dividend payments
: Similar to stocks, a mutual fund can pay out dividends to its investors periodically. They can choose to receive these payouts as cash or to reinvest them in your account.
  • Capital gains
: When an investor sells a fund at a profit, that's known as a capital gain. This gain gets passed off to a fund's shareholders annually.
  • NAV: If your mutual fund's value increases, the price to purchase its shares will also increase. This benefits you if you choose to sell your shares since you would sell at a gain.

Are mutual funds a good investment?

Compared to buying individual stocks or bonds, investing in mutual funds is a more effective way to diversify your investment portfolio.

"Mutual funds are an easy and well-established way to give everyday investors diversification," says Michael Iachini, CFP and head of manager research for Charles Schwab Investment Advisory. "They are well established since the 1920s, and they have a track record of working for investors."

If you're looking to invest in mutual funds, just make sure to keep an eye on costs, since actively managed mutual funds can eat into your profits with expense ratios and commissions. Beginner investors may be better off choosing index funds over actively managed funds to snag earnings without a big price tag.

Pros and cons of mutual funds

Before you add mutual funds to your portfolio, there are advantages and disadvantages that can help you decide whether they are the right fit for your investment style and goals.

  • Offer simplicity and peace of mind with professional fund managers.
  • Typically require a small minimum investment to buy in.
  • Add diversification to your portfolio with various asset classes and industries
  • Ability to invest with exact dollar amounts versus buying shares of stocks at fluctuating prices.
  • Professional management fees can be costly.
  • Not insured by the Federal Deposit Insurance Corporation (FDIC), so there is the risk of losing money.
  • A chance of dilution decreasing the worth of your shares when a successful mutual fund grows too big.
  • You have no control over a fund manager's decisions, which can trigger tax implications like capital gains that add to your taxable income.
  • Since mutual funds trade after markets close, they don't allow for trading during the day and taking immediate advantage of market movements.

Types of mutual funds

Mutual funds aren't hom*ogenous. They are classified into many different types, including the securities they invest in and the investment goals they seek to achieve. Here are seven of the major types:

1. Equity funds

Equity funds invest mostly in stocks and are often categorized by company size and market capitalization. Equity funds can be labeled as growth, value, or blended funds. Growth funds hold shares of companies with potential to outperform the overall market, while value funds are filled with stocks of seemingly undervalued companies. Blended funds mix both growth and value stocks.

"Remember there are more than 10,000 equity mutual funds, yet there are only 2,800 stocks that trade on the New York Stock Exchange," says Clark Kendall, president and CEO of Kendall Capital. "Equity mutual funds do a great job of slicing and dicing the equity markets however you would like to have your market served to you."

2. Bond funds

Bond funds pool investors' money to primarily purchase bonds, from short- to long-term maturities. Some funds include a range of securities including government bonds, corporate bonds, and mortgage-backed securities, while others may focus on a specific part of the bond market.

Bond funds provide quick diversification without buying various bonds individually. Many funds also distribute dividends each month, which you can reinvest.

  • Corporate bonds: issued by corporations that mature over a period of time and pay interest if you hold the bond to maturity
  • Government bonds: issued by the US government, including Treasury securities, with fully taxable interest from a federal level and tax-free from a state level
  • Municipal bonds: issued by local governments and other authorities to pay for projects such as projects such as toll roads, stadiums, and hospitals; interest is exempt from federal taxation and in many cases state and local taxation as well

3. Money market funds

Money market funds are fixed-income mutual funds that invest in short-term debt securities with low credit risk. These funds aim to provide liquidity, maintain a stable share price, and distribute regular income earned on its securities to its investors.

Money market funds are categorized as government, prime, or tax-exempt, depending on the securities held within the fund. Securities often invested in money market funds include short-term US Treasury securities, federal agency notes, certificates of deposit, corporate commercial paper, and municipal agency obligations.

4. Balanced funds

Balanced mutual funds invest in both bonds and stocks, so you get the best of both worlds with steady income and investment growth. Also known as asset allocation funds, these funds typically stick to their original asset mix. If any changes are made, the funds are automatically rebalanced to bring them back to the original allocation.

5. Index funds

Index funds are a type of mutual fund designed to mirror the performance of a particular market index, like the S&P 500 or the Dow Jones Industrial Average. Because index funds are built to match the performance of the target index, they are passively managed investments. This means they require less research and trading from the fund manager, so there are fewer fees and expenses.

It's important to note that while an index fund can be structured as a mutual fund, it can also be an exchange-traded fund (ETF). Index funds are especially favored by investors because they are a low-risk, low-maintenance, low-cost way to see steady returns over time.

6. Specialty funds

Specialty funds, or sector funds, concentrate on securities within a specific industry or market sector, such as real estate, technology, or healthcare. Examples of specialty funds include real estate mutual funds, which invests in REITs and other real estate-related investments. Because specialty funds are focused on specific sectors like health care and technology, they aren't diverse so you'll want to mix these in with other types of funds and assets.

A more recent trend in mutual funds has been "impact investing." They target companies or projects committed to specific social or environmental causes.

These funds cater to investors who are increasingly looking to direct their money to companies that are making positive social or environmental impacts in the world. While many perform well, the return on impact investments may be lower than more traditional investments.

7. Target-date funds

Target-date funds operate with a specific goal date in mind. These funds automatically rebalance the asset mix within their portfolio over time and become more risk-averse as the target date nears. Target-date funds are popular for retirement savings since you can set your retirement date as the target, and let the fund adjust for you.

8. Hybrid funds

Hybrid funds invest in two or more asset classes whereas other mutual funds tend to invest in a single asset class. Hybrid funds often combine stocks and bonds, but may even include commodities like raw materials or precious metals.

The goal of a hybrid fund is to reduce risk by further diversifying the investors' portfolio, even more so than other mutual fund types. Further, hybrid funds can offer an investor a combination of income generation, capital gains, and NAV.

Mutual funds — Frequently asked questions (FAQs)

What are the 4 types of mutual funds?

There are multiple types of mutual funds, such as equity funds, bond funds, money market funds, balanced funds, index funds, specialty funds, and target-date funds. Different kinds of mutual funds invest in different securities for varying financial goals.

Do mutual funds pay interest?

Yes, depending on the type of mutual fund you invest in, you may earn interest on certain assets in your portfolio. These funds often invest in fixed-income securities. Mutual funds that can earn interest are money market funds, bond funds, and balanced funds.

Are mutual funds a safe investment?

Mutual funds are generally considered a safe investment. Compared to individual stocks, investing in mutual funds helps diversify your investment portfolio and lower your overall market volatility. But keep in mind that mutual funds are not risk-free. Just like an investment, there is a level of risk involved and no guarantee that you're investment will turn a profit.

How to start investing in mutual funds

You likely have already invested in mutual funds if you have a 401(k) retirement account. But if you want to start investing in mutual funds outside of employer-sponsored accounts, you can buy and sell them through an online broker with a brokerage account.

You can also buy mutual funds directly from the company that created the fund, like Vanguard - Product Name Only or Fidelity Investments - Product Name Only, although that limits your options to whatever they offer. If you need more guidance with your investments, you could consider working with a financial advisor or broker.

Each fund and each brokerage account may require a specific minimum investment amount to get started. "You typically don't need a lot of money in a mutual fund," says Iachini. "At least have $100 saved up. Once you've chosen a fund, look at its asset class, expense ratio, investment objective, whether that's income, growth, or intentionally trying to be conservative, and who is managing the fund."

It helps to ask yourself a few questions to help narrow down your options. How involved in rebalancing your asset allocation do you want to be? What are you saving for? What do you value? For example, if you're saving for retirement, you'll want to look to target-date funds. Or perhaps you want to look for ESG funds that invest in socially conscious companies.

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As an investment enthusiast with a deep understanding of mutual funds, let's delve into the key concepts mentioned in the article about investing in mutual funds.

Mutual Fund Basics: A mutual fund is a pooled investment vehicle that gathers money from various investors to purchase a diversified portfolio of stocks, bonds, or other securities. The primary aim is to outperform the market, and these funds are professionally managed.

Investing in Mutual Funds: Investors contribute to the fund, becoming part owners of the portfolio. Mutual funds can be accessed through brokers or investment platforms that offer low minimums, account flexibility, tools, resources, and access to human advisors.

How Mutual Funds Work: Actively managed by fund managers, mutual funds involve buying partial ownership of the fund's assets. The Net Asset Value (NAV) determines the fund's price, calculated by dividing the total value of assets by the number of outstanding shares. Mutual funds trade once per day, after the market closes.

Mutual Fund Fees: Fees include annual fund operating expenses (expense ratio) and shareholder fees (load). These fees impact returns, making it crucial for investors to be aware of them. Details can be found in the fund's prospectus.

Making Money with Mutual Funds: Investors can earn through dividend payments, capital gains, and NAV appreciation. Mutual funds offer a more diversified approach compared to individual stocks or bonds.

Are Mutual Funds a Good Investment? Mutual funds provide effective diversification, especially for everyday investors. However, managing costs is crucial, and beginner investors might consider index funds for lower expenses.

Pros and Cons of Mutual Funds: Pros include professional management, diversification, and accessibility with a small minimum investment. Cons involve management fees, lack of FDIC insurance, potential dilution, and limited control over a fund manager's decisions.

Types of Mutual Funds: Several types include equity funds, bond funds, money market funds, balanced funds, index funds, specialty funds, target-date funds, and hybrid funds. Each serves different financial goals and preferences.

FAQs about Mutual Funds: The article covers frequently asked questions, such as types of mutual funds, earning interest, safety of investments, and how to start investing.

Starting to Invest in Mutual Funds: Investors can start by buying mutual funds through online brokers or directly from fund companies. Considerations include minimum investment amounts, asset class, expense ratio, investment objectives, and fund management.

This comprehensive overview provides insights into the world of mutual funds, covering their functioning, fees, types, and considerations for investors. If you have specific questions or need further clarification, feel free to ask.

Mutual funds: Definition, types, and how to invest (2024)
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