Mutual Funds – an Overview
You understand the importance of retirement planning and have begun to stash away some money for your future. You also know that there are a lot of available investment options – stocks, bonds, money market accounts, and certificates of deposit, to name a few. One popular investment vehicle is a mutual fund – a professionally managed pool of money that’s collected from a group of investors. A mutual fund is invested in a combination of financial products including stocks, bonds, currencies, futures, commodities, and money market accounts. Because a mutual fund has several different types of assets, it allows you to spread your money – and subsequently your risk – through a single investment. Mutual funds are a popular long-term investment for people who lack the time, resources, and savvy of a professional investor. To help you understand more about mutual funds, this article covers the following topics:
- Learn how a mutual fund works
- Active versus passive funds
- Understand mutual fund expenses
- Invest in a mutual fund
Learn how a mutual fund works
Mutual fund prices fluctuate based on stock market performance but are not exactly like stock. A mutual fund is a company that receives shareholders’ money and then makes investments with its cash pool. When you buy mutual fund shares, you own part of the fund in proportion to the amount you’ve invested. Individual investors don’t choose which assets the fund invests in. The fund manager makes these decisions. You can learn about a mutual fund by reading the fund prospectus – a summary of the investment strategy, costs, and historical performance of the fund. The government requires all funds to provide a prospectus to each investor or to potential investors who request one. You can also find much of this information on websites such as Morningstar or Finra that specialize in mutual fund research.
Because mutual funds may consist of a variety of financial products, you make money in several different ways. Stocks earn dividends, bonds earn interest, and sales of securities that have increased in price generate a capital gain. Most funds distribute these earnings to investors; if so, your account is credited quarterly or annually based on how much money the fund earned and what percentage of ownership you have. Funds also have a Net Asset Value (NAV), which is the price of each individual share. If you sell your shares for a higher NAV than you purchased them for, you’ll earn money just as you would when selling a stock that has appreciated in price. Like stocks, mutual funds also carry the risk of losing value, which could generate a loss if you sell below your purchase price.
Active versus passive funds
As a beginning investor, you should understand two main types of funds – active and passive.
- Active mutual funds – as the name implies – are funds that are actively managed. Active fund managers frequently trade stocks and bonds and sell securities based on market analysis. While mutual funds are less risky than single stocks, active investing may increase the investment risk of the fund. Historical performance indicates that it’s very difficult for an active mutual fund to consistently beat the market.
- Passive mutual funds – also called index funds – track the performance of a stock market index like the S&P 500. Fund managers purchase stocks in proportion to their presence in the index with the goal of closely matching the index’s market performance. For example, the S&P 500 is an index that tracks 500 large capitalized companies in the United States. An index fund based on the S&P 500 includes stock from these 500 companies in proportion to each company’s market value. In theory, the index fund should generate very similar returns to the index. Passive funds require little analysis and management, which reduces their costs and makes them a good choice for investors.
Understand mutual fund expenses
Mutual funds have unavoidable expenses, but research can help you find funds with minimal costs. There are several types of mutual fund expenses:
- Transaction fees – A transaction fee is paid when purchasing or selling your fund shares. You typically must purchase mutual funds through a brokerage firm, which is a company that buys and sells funds and equities in exchange for a fee or commission. Before you purchase a mutual fund, find out if there is a transaction fee. Many companies – such as Scottrade, Vanguard, or Fidelity – charge a flat transaction fee for some funds but not for others. Steer clear of brokerage firms that charge a transaction fee regardless of the fund.
- Loads – A load is a sales charge that the fund assesses when you purchase or sell your shares. The charge is a percentage of your total investment and is usually less than five percent. A front-end load fund assesses this fee when you purchase the fund, and a back-end load fund charges an exit fee if you sell your shares within the first year. In general, you should look for a no-load fund.
- Expense ratios – The fund expense ratio is the percent of the fund’s assets used to pay operating expenses. All funds have an expense ratio, but they vary quite a bit. Since passive funds require less management, the expense ratio is typically under one percent and can be as low as one-tenth of a percent. Active funds typically have an expense ratio of one to two percent. Although these fees seem small, they can add up over time if you choose a fund with a relatively high expense ratio.
Invest in a mutual fund
Before you invest in a mutual fund, open an account at a brokerage firm. There are dozens of firms to choose from, with varying levels of service and fees. Limited service firms such as Scottrade don’t provide guidance when you select mutual funds; however, transaction fees are fairly low. Full service brokerages such as Edward Jones help you plan an investment strategy but generally charge higher fees.
When you invest in a mutual fund, you can purchase shares for a general investment account or for a dedicated retirement account like an IRA or 401k. Most mutual funds require a minimum balance for your initial investment. Opt for an IRA if you’re just beginning to invest and don’t have a lot of cash. Most mutual funds have lower minimums for qualified retirement accounts.
There are two important things to remember about mutual funds:
- Mutual funds are not risk-free – Unlike savings accounts and CDs, investments in mutual funds are not insured by the FDIC. If the stock market loses value or if the fund is mismanaged, you could lose money.
- Mutual funds are long-term investments – While you can sell a mutual fund at any time, your investment is not as liquid as it would be in a money market account, savings account, or other cash investment. You’ll pay short-term capital gains or additional fund fees if you don’t hold the fund for a certain period of time. A funds’ value fluctuates from year to year, but historically, the value of mutual funds has increased over several decades. As a twenty or thirty something investor, you’re at an ideal age to begin investing in mutual funds.
Understanding how mutual funds work and why they’re a good investment option are your first steps to a comfortable financial future. When you’re ready to start investing, check out WhatCollegeForgot.com’s guide to selecting mutual funds.
By: Jessica Bayliss
7-12-2009
Jessica Bayliss is a freelance writer specializing in finance and education. She has degrees from the University of Illinois and Texas A&M-Kingsville and is still learning all about what college forgot.
