How to invest in mutual funds
Looking to diversify your investment portfolio? Mutual funds could be a good addition. Here's how they work.
Looking to get into investing but not sure where to begin? Mutual funds could be a good starting point. They let you club together with other investors to invest in a wider range of assets than you might be able to afford individually. Read on to find out why this is a good thing for your investment portfolio.
What is a mutual fund?
A mutual fund is a professionally-managed fund comprising a pooled collection of assets, which may include stocks, bonds, and other securities. It’s called a mutual fund because, rather than investing directly in individual assets, you pool your money “mutually” with other investors. This means you each get exposure to a little bit of all the assets in the fund.
When you invest in a mutual fund, you don’t directly own the assets within it. Instead, you own a share of the fund itself, and (along with your other mutual investors) share in the profits and losses of the underlying holdings. It’s a good way to instantly diversify your investment portfolio. It allows you to spread risk by investing in lots of assets at once, much more cost-effectively than if you tried to buy every stock, bond or other asset individually.
What are the different types of mutual fund?
Mutual funds can be categorised in a couple of ways: by whether they’re active or passively managed, and by the nature of the assets they hold.
Active vs passive mutual funds
- With passive funds, the fund manager simply aims to replicated the performance of a specific benchmark. This is often a stock market index, such as the FTSE 100, or the S&P 500. The fund manager’s role is mainly to keep up with changes in the benchmark being tracked, and buy and sell assets accordingly. The returns you get from the fund will closely replicate the performance of the benchmark, with a small deduction for fees.
- With actively managed funds, the fund manager plays a very “active role” in how the fund operates. Rather than simply trying to replicated the performance of a benchmark, an active fund manager will attempt to beat the market. They’ll do this by buying and selling assets in accordance with the fund strategy. Investing in actively managed mutual funds will give you a chance of bigger returns than passive funds, if the fund manager consistently gets it right. But markets are hard to predict, even for professionals. In practice, passive funds often perform better than actively managed ones. Plus, because the assets in active funds tend to be traded more frequently, the extra fees incurred will eat into your returns.
Mutual funds by type of asset
Mutual funds can contain hundreds, or in some cases thousands, of underlying assets, of many different types. Some of the most common categories of mutual fund include:
- Bond, or fixed-income funds. These include bonds and other assets that provide a predictable, fixed income (often in the form of interest). They tend to be regarded as lower risk than investing in funds containing stocks. The downside is they offer less potential for exciting rewards.
- Stock funds. Also known as equity funds, these mutual funds invest in a range of stocks. These may be the stocks included in a given index, or stocks that are hand picked by an active fund manager in a bid to beat the index. Stocks tend to carry higher risk than bonds, but offer the potential for higher reward.
- Balanced funds. These invest in a mix of bonds, stocks and other securities. They may even do this by investing in bond or stock funds, and are sometimes referred to as “funds of funds”. They can be popular as part of a pension fund, as with some funds the balance of assets can be adjusted over time, allowing you to reduce your risk level as you approach retirement.
This isn’t an exhaustive list, and there can be plenty of fund sub-categories. For example some funds may focus on a specific sector of the market, such as technology or commodities. Others may focus on international markets.
What are the advantages of investing in mutual funds?
Investing in mutual funds gives you exposure to a diversified range of assets without the cost of investing in each asset individually. Shares in mutual funds are straightforward to buy and sell using an online investment account. Plus they’re relatively low effort, as the day-to-day management is done by a professional fund manager.
What are the disadvantages of investing in mutual funds?
The key risk of investing in mutual funds is the same as for pretty much any investment. There’s no guarantee you’ll make money and a risk that you may even lose it, especially if fees eat into your capital during a downturn in the market. The diverse nature of mutual funds will help mitigate this risk, though, as will staying invested for the long run.
In addition, you won’t have control over the assets that make up the fund, so may find you’re indirectly investing in some companies that you wouldn’t choose yourself. That said, many investors happily accept this trade-off in exchange for not having to put lots of time and energy into investment management.
How are mutual funds different from ETFs?
In many ways mutual funds are very similar to ETFs. Both involve buying shares in a fund that comprises a collection of assets, such that you don’t own the underlying assets directly but benefit from their returns. And their more diversified nature means that both are generally regarded as less risky than investing in individual assets, such as stocks.
However there are a few key differences.
Differences between mutual funds and ETFs
|Can only be bought and sold at the end of the day after market trading closes (though you can put in an order to buy or sell at any time via your investment platform).||Can only be bought and sold at the end of the day after market trading closes (though you can put in an order to buy or sell at any time via your investment platform).|
|You can choose between a wide range of passive and actively managed funds.||The majority of ETFs are passive funds that track an specific benchmark, such as a stock market index. While active ETFs are growing in popularity, you’ll likely have fewer options than with mutual funds.|
|May have higher fees than ETFs, in particular actively managed mutual funds. Fees for passive mutual funds may be similar to passive ETFS.||Tend to have lower fees on average, though this is in part due to the fact that most ETFs are passive and therefore incur lower management fees.|
At first glance, the more flexible trading times of ETFs might seem an advantage. But, in practice, this is only a big deal for those looking to time the market and make money out of very short-term market movements – such as day traders. For long-term investors, this is unlikely to matter too much.
How can I invest in a mutual fund?
Investing in a mutual fund doesn’t have to involve a huge initial outlay. Some providers allow you to invest from just a few pounds, though others may have higher minimum investments. Once you’ve weighed up your options and decided mutual funds would make a good addition to you investment portfolio, there are a few steps to follow.
Step 1: Decide on the type(s) of mutual fund you want, and how much you want to invest
You’ll need to choose what types of mutual fund are right for your portfolio. For example:
- Do you want to focus on passive or actively managed funds, or a mix of both?
- Do you want your funds to include mainly stocks, or lower-risk/lower-reward bonds?
- Do you want to opt for funds that focus on a particular stock market index, or a particular market sector (such as tech stocks)? Opting for funds that cover a mix of UK and overseas investments may also help diversify your portfolio.
- Do you want funds that focus on growth, or ones that will pay an income in the form of dividends or interest?
All of this should be informed by your investment goals. For example, you can probably afford to take more investment risk with long-term than short-term goals. When selecting specific funds, you should also look at past performance. While this needs to be taken with a pinch of salt, as past performance isn’t a guarantee of future success, a good track record can help inform your decisions.
Remember that if all of this sounds like gobbledygook, and you need a bit of help, you can always speak to a professional financial adviser who can recommend specific funds to suit your needs. You’ll need to pay for professional advice, but this could be worth it, especially if you have a decent chunk of money to invest.
Step 2: Choose an investment account
Unless a professional adviser is managing your investments on your behalf (for a fee), you’ll need to open an account. These days many people are opting for online investment platforms to manage their investments. Make sure that the account offers a good range of mutual funds to suit your needs (or, if you have specific funds in mind, that they offer those funds). Some accounts are offered directly by fund providers, and these may only offer access to their own funds – such as Blackrock and Vanguard. Other online dealers, such as Fidelity and Hargreaves Lansdown, offer access to funds from a wide range of providers, sometimes including their own.
You’ll also want to compare platform fees, and the information and tools on offer to help you make investment decisions.
Step 3: Open your chosen account, deposit money, and buy your chosen mutual funds
You’ll need to supply basic details such as your name, address and contact details, plus provide proof of ID. You may also be asked to link your bank account. Payments into your account can usually be made using either a debit card or a bank transfer.
Once your account is set up and you’re signed in, search for your chosen funds, and follow the steps to make a purchase.
Step 4: Monitor and manage your portfolio
Sadly making your initial investment isn’t quite the last step. Investing is a journey, not a one-off event. If you invest in funds, the fund manager will do the bulk of the legwork. But you’ll still want to check in occasionally to make sure your portfolio balance still meets your needs. And, when finances and other circumstances allow, to deposit more money over time and help your investments grow.
Where can I invest in mutual funds?
A number of online investment platforms let you invest in mutual funds. However, some platforms are cheaper than others, and some have a wider choice of funds than others. So do a bit of research before picking a provider.
Is investing in mutual funds profitable?
It certainly can be. Otherwise why would you bother? You can make money from mutual funds in a couple of ways, depending on the type of mutual fund:
- Capital gains. If (as you would hope) the assets held in a mutual fund grow in value over time, the difference between the price you initially paid and the price you sell at is known as a capital gain. If it exceeds a certain level, known as your annual exempt amount, you may need to pay capital gains tax.
- Dividends or interest. Some mutual funds pay out an income in the form of share dividends or interest from bonds. You can often choose whether to have this income paid to you directly, or reinvested in the fund. As with capital gains, dividends or interest income that exceeds your annual allowances may be subject to tax.
Bear in mind that the value of investments can go down as well as up. If it goes down, and you need to access your money, you could end up with less than you paid in. You can minimise this risk by keeping your money invested for a longer timeframe. 5 years is the recommended minimum.
Pros and cons of mutual funds
- Mutual funds offer instant diversification, as a single fund includes multiple assets
- You have the assurance that a professional fund manager is looking after your investment
- Mutual funds are typically lower-cost than investing in individual assets
- You have the option to invest in active funds that offer a chance of “beating the market”
- You have no control over the specific assets that are included in the fund
- Because they’re lower risk, mutual funds may also offer less opportunity for big returns
- Fees for some funds, especially actively-managed ones, can be expensive – so keep an eye out.
Mutual funds can be a straightforward, low-cost and (relatively) lower-risk way to get started with investing, or to diversify an existing portfolio. There are lots of different types, to cover a range of sectors, regions and risk appetites. So, buying shares in a handful of mutual funds could broaden your investments significantly, helping you manage risk and meet your investment goals.
Frequently asked questions
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