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A beginner’s guide to mutual funds
The benefits, the risks and what you need to get started in mutual fund investing.
Mutual funds are professionally managed portfolios that invest in a variety of stocks, bonds and other assets. So investing in mutual funds takes the time and expertise out of prudently picking your own stocks and other investments.
How do mutual funds work?
Asset management companies pool money from several investors and use it to buy stocks or other investments within a mutual fund. As an investor, you gain based on the positive performance of the investments in the mutual fund and the proportion of shares you own.
The price of a mutual fund share is known as its net asset value (NAV). It reflects the combined price of the securities in the fund and is typically set at the end of the trading day. So if the price of your mutual fund shares increases, you can sell these for a profit.
But some mutual funds also make regular payments to investors in the form of dividends from stocks or interest from bonds held in the mutual fund.
Because a mutual fund pools money from different investors, you may not need to invest a large sum in one share of a major company’s stock. In fact, many mutual funds invest in the stocks of leading companies and require relatively small minimum investments.
Each mutual fund has a specific objective like long-term growth. Its managers use their expertise to carefully pick assets they believe will help the fund meet those goals. They continually monitor these funds and add or remove assets as they see fit based on market conditions.
Types of mutual funds
There are several types of mutual funds. These are typically categorized based on the type of assets they invest in such as stocks of large companies or investment strategies such as growth-oriented. In some cases, it’s a combination of the two. Here are some examples.
- Stock (equity) funds: As you guessed, these mutual funds invest primarily in stocks. There are subcategories of stock funds, typically based on the size of the companies they invest in and the investment strategy.
- Large-cap mutual funds: These mutual funds invest in companies with market capitalizations of more than $10 billion. Market cap is taken by multiplying the price of a single share of a company’s stock by the number of shares outstanding.
- Small-cap mutual funds: These mutual funds invest in companies with market caps between $300 million to $2 billion.
- Mid-cap mutual funds: These funds invest in companies with market caps that fill the gap between large-and-mid caps.
- Strategy mutual funds: In some cases, stock funds are named after the size of the companies they invest in and the investment strategy employed by the fund managers. An example would be a large-cap value fund. These mutual funds invest in large companies that are in fundamentally good financial shape but may be undervalued in terms of share price. Meanwhile, growth funds invest in companies that have proven track records and are expected to keep growing.
- Bond (fixed-income) fund: These funds invest in assets that pay interest. These can include corporate bonds, government bonds and more.
- Balanced funds: These invest in different types of assets such as stocks, bonds and real estate. Many balanced funds are named after the level of risk they take on based on the types of assets they invest in. A conservative fund would invest mostly in safer securities like bonds. An aggressive fund would invest mostly in growth-oriented assets like stocks.
- Index funds: These mutual funds invest in stocks within a particular index such as the S&P 500, which contains some of the biggest companies in the country. To minimize risk, fund managers attempt to match the performance of the corresponding index rather than beat it. That’s the strategy employed by actively managed funds. Index funds can be seen as passively managed funds.
- Money market funds: These invest in generally safe securities like Treasury Bills. It’s a good place to park your money for safety because you’re not likely to lose it. But money market funds generally gain small returns similar to a typical savings account.
What’s the difference between a closed-end and open-end fund?
A closed-end fund sells a fixed number of shares through an initial public offering. An open-end fund sells shares directly to investors. This means you can buy an open-end fund through a brokerage account.
How to invest in mutual funds
After you’ve researched your mutual funds and know you’re interested, it’s time to invest. Here’s how to do it.
- Open a brokerage account.
- Look up the mutual fund’s stock ticker.
- Decide how many shares you want to buy.
Compare fund trading platforms
You’ll need a platform that offers mutual funds; not all do, and not all will let you trade all funds.
Benefits of mutual funds
Mutual funds may be great for new investors who want access to a professionally managed portfolio. Here are some of the benefits.
- Instant diversification: If you put all your money in one stock and that stock plummets, you’ll take a serious hit. But if one stock in a mutual fund goes down, it can be offset by the positive performance of the other stocks in it. This is the benefit of diversification. You’re not putting all your eggs in one basket when you invest in mutual funds.
- Pooled investment vehicle: Mutual funds pool money from several investors to buy securities. That can bring down the costs of creating your own mutual fund by purchasing shares of several different stocks.
- Professionally managed: Mutual funds are run by experts from large investment-management firms.
What are the drawbacks of mutual funds?
Like any investment, mutual funds involve risks.
- Fees: Mutual fund fees will vary across funds. Here are some common ones to look out for.
- Expense ratio: This is the fee that investment companies collect for running the mutual fund. It’s expressed as a percentage. So a proportional expense ratio would typically be deducted from your account based on the number of shares you own.
- Sales loads: These are commissions that brokers collect for selling mutual fund shares to you. These can be triggered when you buy shares of a mutual fund or after you sell your shares before a specific time frame. But look for no-load funds as many funds have done away with these fees.
- 12b-1 fees: These are marketing and distribution fees collected by money managers. Because they’re operational costs, they’re usually factored into the fund’s expense ratio. By law, a 12b-1 fee can’t exceed 0.75%.
- Potential for mismanagement: Fund managers may engage in unnecessary trading and excessive replacement of assets in the fund, which can raise risk.
- Taxes: Because of gains and turnover within a fund, investors typically receive distributions from the fund, which are considered capital gains. So you’ll owe capital gains taxes.
More fund trading resources
Mutual funds are diversified and professionally managed portfolios. But there are thousands of mutual funds out there. Important factors like fees, objectives and asset allocations would vary across funds. So it’s important to do your homework. You should also compare brokerage accounts to find the one that’s right for you before you invest in a mutual fund.
Frequently asked questions
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