- What they are: A professionally managed pool of stocks, bonds and/or other instruments that is divided into shares and sold to investors.
- Pros: Diversification; liquidity; simplicity; affordability (low initial purchases); professionally managed.
- Cons: Fluctuating returns; over-diversification; taxes; high costs; professional management doesn’t guarantee good performance.
- How to invest: Directly through mutual fund companies; discount and full service brokerage firms; banks; insurance agents.
Mutual Fund Basics
A mutual fund is a company that pools money from many different investors to invest in a set portfolio of stocks, bonds and other securities. The fund’s professional money manager (or team of managers) researches, selects and monitors the performance of the fund’s portfolio. Each investor owns shares of the fund, which represent a portion of the fund’s holdings. The price that you pay for a mutual fund is the fund’s per share net asset value (NAV) plus any shareholder fees imposed by the fund. Most funds calculate their NAV at least once each business day, usually after the close of the major U.S. exchanges. Because mutual fund shares are redeemable, you can sell your shares back to the fund (or to a broker acting on behalf of the fund) on any business day.
There are three ways in which you can make money from mutual funds:
- Dividend payments. If the fund earns income in the form of dividends and interest on its portfolio’s securities, the fund will pay its shareholders close to all of the income it has earned, less disclosed expenses.
- Capital gains distributions. If a fund sells a security that has increased in price, the fund will distribute the capital gains, less any capital losses, to investors at the end of the year.
- Increased NAV. A higher NAV represents an increased value for your mutual fund investment.
Typically, you can decide if you want to receive dividend payments and capital gains distributions, or if you want the money reinvested in the fund to purchase additional shares.
Open-End Vs. Closed-End Funds
Most mutual funds are open-end funds. Open-end funds have no limits regarding the number of shares that the fund can issue and sell. As a result, the growth potential of the fund, in terms of investment dollars, is open-ended (and not limited). Even though there are no limits, a fund manager can decide to close the fund to new investors if the fund would become too large to effectively manage.
Closed-end funds, on the other hand, establish at the outset the number of shares that will be available for sale to the public. After the shares have been sold through an initial public offering (IPO), the fund is closed. New investors can buy into the fund only if there is a willing seller.
Types of Funds
Most mutual funds are money market funds, bond funds (or fixed income or income funds) or stock funds (also called equity funds). As with most investments, the higher the potential returns, the higher the risk.
Money market funds
Money market funds are considered lower risk than other types of mutual funds. By law, they are limited to investing in certain high-quality, short-term investments issued by the U.S. government (such as Treasury bills), U.S. corporations, and state and municipal governments. Returns tend to be twice what you would expect to earn in a savings account, and a bit less than a certificate of deposit (CD). These funds attempt to maintain a NAV at a stable $1 per share, and the fund pays dividends that generally reflect short-term interest rates.
Bond funds have higher risk than money market funds, in part because they seek higher returns. Because there are many different types of bonds, and these funds are not restricted to high-quality, short-term investments (like money market funds are), the funds vary greatly in terms of risks and rewards. Bond funds are exposed to the same risks associated with bonds: credit/default risk, prepayment risk and interest rate risk (discussed in the Bonds section of this tutorial).
Funds that invest in stocks make up the largest category of mutual funds. Stock funds, or equity funds, utilize various strategies. Growth funds, for example, focus on stocks that have the potential for large capital gains. Income funds, on the other hand, invest in stocks that pay regular dividends.
Stock funds are exposed to the same market risk as individual stocks, and prices can fluctuate - at times dramatically - due to a variety of factors, including the overall strength of the economy.
Target Date Funds
Target date funds are structured to adjust allocations based on a target retirement date. From an investor’s standpoint, they offer an easy way to manage investments based on the number of years they have left until retirement. Investors make one decision: select the target date fund that most closely matches the year they expect to retire. For example, if it is 2013 and you expect to retire in 17 years, you might select a target date fund of 2030 or 2035.
As a target fund approaches its target date, it automatically shifts to more conservative investments by moving assets from higher-risk instruments such as equities into low risk holdings such as fixed-income securities. It is important to remember, however, that these funds hold the same risks as other mutual funds; they do not guarantee any type of income stream for retirement.
Financial AdvisorMore than 80 million people, or half of the households in America, invest in mutual funds. No matter what type of investor you are, there is bound to be a mutual fund that fits your style.
Financial AdvisorLearn how mutual funds work, why they are so popular and how younger investors can get started by putting mutual funds in their IRAs or 401(k)s.
InvestingLearn about the basics of trading and investing in mutual funds. Understand how the fees charged by mutual funds can impact the performance of an investment.
InvestingThis investment is very popular, but that doesn't mean it comes without risk.
Managing WealthFind out why you should include balanced funds in your portfolio, including the importance of customizability, diversification and professional management.
InvestingThe growth of mutual funds isn't always cause for celebration. Read on to find out why.
InvestingLearn about the advantages of investing in mutual funds rather than individual stocks, including the benefits of affordability, oversight and diversification.
InvestingFind out which five types of mutual funds you should avoid in your 401(k), including why buying this year's hottest fund is likely a losing bet.
InvestingLearn about considerations for investors when buying shares in a mutual fund for a long-term investment, including fees, type of management and portfolio goals.
Financial AdvisorLearn five of the "secrets" about mutual funds that can have a significant impact on mutual fund choices and investor profitability.