Mutual Fund Basics

Mutual funds are popular investment securities used by all types of investors, including beginners and financial professionals. But how well do these investments suit you?

Learn some mutual fund basics, including how they work, the different types of funds to choose from and how to pick the right mutual funds for your portfolio.

What Are Mutual Funds?

Mutual funds are investment vehicles that pool money from multiple investors to invest in a diversified portfolio of securities, such as stocks, bonds and other financial instruments. These funds may be actively managed by professional fund managers or investment firms.

Mutual funds can be a more efficient way to gain access to a diverse range of dozens or hundreds of investment assets, all packaged within one security. This makes mutual funds a potential option for investors who are starting out and prefer a manager to pick the holdings rather than do the research and trading themselves.

Mutual Fund Basics: How Do Mutual Funds Work?

When you invest in a mutual fund, you're essentially buying shares or units of the fund, and your money is combined with that of other investors. The fund manager then uses the pooled money to buy certain types of investment securities, such as stocks or bonds, according to the fund's investment objectives and strategies.

The structure of mutual funds allows investors with relatively small amounts of money to gain exposure to a diversified portfolio that would be difficult to achieve individually. Mutual funds are also diversified by design, which means they spread the investment across various securities, reducing the risk associated with investing in a single asset. By holding a diversified portfolio, the fund aims to mitigate the impact of poor performance from any individual investment. It's important to understand though that using diversification as part of an overall investment strategy doesn't assure a profit or protect against loss in a declining market.

Additionally, mutual funds have different risk profiles, expense ratios and investment strategies. So it's essential to understand the important mutual fund terms, research the different types, and choose funds that align with your financial goals and risk tolerance.

How Do Mutual Funds Compare to Stocks?

Mutual funds and stocks are both investment options, but they differ in several key aspects. For example, some investors may prefer the convenience and diversification offered by mutual funds, while others may enjoy the control and potential rewards of investing in individual stocks. Ultimately, the choice between mutual funds versus stocks depends on your investment goals, risk tolerance, time commitment and preference for diversification.

Here are some of the key differences between mutual funds and stocks:

Diversification

Mutual funds provide instant diversification by pooling investors' money to create a portfolio of various securities. This diversification helps reduce the risk associated with investing in a single stock. However, stocks represent ownership in a specific company, so their performance is tied directly to the fortunes of that company, which presents greater risk in comparison.

Professional Management

Mutual funds are managed by professional fund managers who make investment decisions on behalf of the investors. With stocks, investors must research and select individual companies themselves.

Accessibility

Mutual funds offer a lower barrier to entry compared to many stocks. You can typically invest in mutual funds with smaller amounts of money, whereas it may take a larger amount of money to build an entire portfolio consisting of individual stocks.

Liquidity

Mutual funds generally offer daily liquidity, allowing investors to buy or sell shares at the fund's net asset value at the end of each business day. In contrast, stocks can be bought or sold throughout market hours, providing more immediate liquidity.

Risk and Return

Both mutual funds and stocks carry investment risk, but the level of risk can vary. Mutual funds can be designed to target different risk levels, depending on the fund's investment strategy. Stocks, however, can potentially offer higher returns, but they carry a higher level of risk compared to a diversified mutual fund.

Control and Flexibility

Investing in individual stocks allows you to have direct control over your portfolio composition. In other words, you can choose which stocks to buy, sell or hold. With mutual funds, you rely on the fund manager's decisions. Your ability to customize the portfolio is limited to selecting different funds.

What Are the Different Types of Mutual Funds?

There are many different types of mutual funds, each with its own investment objective, asset class focus and risk profile. Here are some common types of mutual funds:

Equity Funds/Stock Funds

These mutual funds primarily invest in stocks or equity securities. They can have different focuses, such as large-cap, mid-cap, small-cap, growth-oriented, value-oriented, sector-specific or international stocks. Equity funds aim to provide capital appreciation over the long term.

Bond Funds/Fixed-Income Funds

Bond funds invest in fixed-income securities, such as government bonds, corporate bonds, municipal bonds or other debt instruments. They aim to generate income for investors through interest payments and potential capital appreciation. Bond funds can vary in terms of credit quality, duration and yield.

Money Market Funds

Money market funds invest in short-term, low-risk securities, like Treasury bills, commercial paper, certificates of deposit and short-term bonds. They aim to provide stability and preserve capital while offering a modest level of income.

Hybrid Funds

Also known as balanced funds or asset allocation funds, hybrid funds invest in a mix of stocks, bonds and sometimes cash or other assets. The allocation can be fixed or adjusted based on market conditions. The objective is to achieve a balance between growth and income while managing risk

Index Funds

These funds aim to replicate the performance of a specific market index, such as the S&P 500. Index funds generally have lower expense ratios compared to actively managed funds since they aim to match the performance of the underlying index rather than outperform it.

Sector Funds

Sector funds concentrate their investments within a particular sector of the economy, such as technology, health care, energy or financial services. These funds provide exposure to specific industries or sectors and may be suitable for investors seeking targeted exposure or who have a strong view of a specific sector.

International/Global Funds

These funds invest in securities outside of the investor's home country. International funds focus on a specific region or country, while global funds have broader international exposure across multiple regions.

Target-Date Funds

Also known as target retirement funds, target-date funds are designed to align with a specific target retirement date. They automatically adjust the asset allocation mix over time, becoming more conservative as the target date approaches. Target-date funds offer a simplified investment strategy for investors planning for retirement.

What Are Some Benefits and Risks of Mutual Funds?

Mutual funds offer several benefits, such as diversification and professional management. However, there are disadvantages, such as market risk and lack of control, that investors should consider before investing.

Here's an overview of the benefits and risks associated with mutual funds:

Benefits of Mutual Funds

• Diversification. Mutual funds allow investors to own a diversified portfolio of securities without needing to purchase individual assets. This diversification may help reduce the impact of poor performance from any single investment and can potentially lower overall investment risk.
• Professional management. Mutual funds are managed by experienced professionals who make investment decisions on behalf of the investors. These fund managers have expertise in researching and selecting securities, which can potentially lead to better investment decisions and returns.
• Affordability. Mutual funds typically have lower investment minimums compared to purchasing individual securities. This can allow investors with smaller amounts of money to access a diversified portfolio and professional management.
• Convenience. Mutual funds handle administrative tasks, such as record-keeping, tax reporting and dividend distribution. This convenience can save investors time and effort compared to managing individual investments.

Risks of Mutual Funds

• Market risk. Mutual funds are exposed to market fluctuations, which can affect the value of the underlying securities in the portfolio. If the overall market experiences a downturn, the value of the mutual fund's holdings may decline.
• Manager risk. The performance of a mutual fund relies heavily on the skills and decisions of the fund manager. If the manager makes poor investment choices or fails to adapt to changing market conditions, it can negatively impact the fund's returns.
• Fees and expenses. Mutual funds charge fees and expenses, such as management fees, administrative costs and sales loads (if applicable). Collectively measured as an expense ratio, these expenses can reduce the overall investment returns and should be carefully considered.
• Lack of control. When investing in a mutual fund, you rely on the fund manager to make investment decisions. This means you have less control over the specific securities held in the portfolio compared to owning individual stocks or bonds.
• Tax implications. Mutual fund distributions, such as dividends or capital gains, are subject to taxes. Even if you don't sell your shares, you may still be liable for tax payments on the distributions made by the fund.
• Potential for underperformance. Few mutual funds consistently outperform their benchmarks or peers. There is a risk that a mutual fund may underperform due to various factors, such as market conditions, investment strategy or manager performance.

How to Pick a Mutual Fund in 10 Steps

When you decide to pick your own mutual fund, it's important to carefully consider your investment goals, risk tolerance, time horizon and investment preferences, as well as other factors.

Here are some steps to help you in choosing:

1. Set Your Investment Goals

Clearly define your investment objectives. Are you investing for retirement, saving for a specific goal or seeking regular income? Understanding your goals will guide your fund selection process.

2. Assess Your Risk Tolerance

Evaluate your comfort level with risk. Determine if you are more conservative, moderate or aggressive in your investment approach. This will help you choose a mutual fund that aligns with your risk tolerance.

3. Determine Your Time Horizon

Consider your investment time frame. Are you investing for the short, medium or long term? Longer time horizons generally allow for a greater degree of volatility and potential for higher returns.

4. Research & Compare Funds

Conduct thorough research on different mutual funds. Look at their investment objectives, historical performance, expense ratios, fund manager track record and risk profiles. Analyze how the funds have performed during various market cycles. Bear in mind that past performance is never a guarantee of future results.

5. Consider Fund Fees & Expenses

Assess the fees and expenses associated with the mutual funds you are considering. Look at the expense ratio, which includes management fees and other costs. Lower expense ratios are generally more favorable for investors.

6. Understand the Fund's Investment Strategy

Evaluate the fund's investment strategy and determine if it aligns with your investment goals and risk tolerance. Consider factors such as asset allocation, sector focus and investment style (e.g., growth, value or blend).

7. Check Fund Manager Expertise

Evaluate the experience and track record of the fund manager or management team. Look for consistency in their investment approach and how they have managed the fund through different market environments.

8. Review Fund Holdings

Examine the fund's holdings to gain insight into the types of securities it invests in. Ensure that the fund's portfolio composition matches your investment preferences and aligns with your desired level of diversification.

9. Consider Fund Size & Liquidity

Assess the size of the mutual fund and its liquidity. Larger funds, as measured by assets under management, may be more stable and have more resources, while smaller funds can be more nimble. Additionally, consider the fund's redemption policy and how easily you can buy or sell shares.

10. Seek Professional Guidance

If you feel overwhelmed or uncertain, consider consulting with an investment professional who can provide personalized guidance based on your individual circumstances and investment goals.

Bottom Line

What are mutual funds, and how do you choose the best one for you? It's important to thoroughly research and understand mutual fund basics and the specific mutual fund you are considering, including its investment objective, past performance, expense ratio and risk profile. Assessing your own investment goals, risk tolerance and time horizon is crucial in determining if a particular mutual fund aligns with your needs.

Consulting with a financial professional can provide valuable guidance in considering appropriate mutual funds for your portfolio.