What are Mutual Funds? The Basics

Building a diversified investment portfolio comprised entirely of individual stocks and bonds isn’t financially feasible for many investors. This is precisely where mutual funds come into play, offering an alternative way to gain exposure to numerous stocks, bonds, and other investments within a single fund—and they can be relatively inexpensive!

What is a mutual fund?

A mutual fund is an investment company that pools money from investors to purchase a diversified portfolio of stocks, bonds, and other assets. The combined holdings of a mutual fund are collectively known as its “portfolio.”

Portfolio funds are managed by professional money managers who are tasked with matching the fund’s investment objectives to details included in its prospectus, a document filed with the federal government regulatory agency (Securities and Exchange Commission) that outlines fund objectives, strategies, fees, etc. so investors can make informed decisions.

Investors can buy shares in a mutual fund—each representing a portion of ownership—and thus share proportionately in the profits (or losses) the fund generates.

Mutual fund costs

One appealing feature of mutual funds is that upon meeting the minimum investment amount (typically between $1,000 and $5,000), you can continue contributing as much (or as little) as you want.

Known as its “net asset value” (NAV, sometimes expressed as NAVPS), the price of a mutual fund share is calculated by dividing the total value of the portfolio (less any liabilities) by the total amount of outstanding shares. Mutual fund share prices fluctuate daily since asset prices and the number of outstanding shares change constantly.

Types of mutual funds

A variety of mutual funds suit various objectives. Some specific fund types include:

Actively managed
With actively managed mutual funds, the portfolio manager decides which stocks or bonds to buy, sell, or hold based on a given strategy to ultimately achieve and maintain fund objectives.

Index funds
Index mutual funds are passively managed, meaning the fund manager’s objective is to replicate the performance of an underlying index such as the S&P 500, Russell 2000, or a host of other stock or bond indexes. Stocks or bonds are therefore bought or sold to closely match the configuration of a given index.

Stock funds
Stock mutual funds contain a variety of individual stocks, perhaps including funds that buy stocks of large companies (such as Microsoft or Apple), small companies just starting out, and/or mid-sized companies on the rise. This can also include growth or value-oriented stocks or a blend of the two and domestic or international, representing stocks of developed or emerging markets.

Bond funds
Bond mutual funds hold various types of individual bonds including Treasury, corporate, municipal, agency, or high-yield bonds. These funds—which may hold bonds of multiple durations—can be actively managed or passively follow one or many bond indexes.

Sector funds
Sector funds are mutual funds that focus their investments within a specific sector such as technology, energy, etc. These provide an excellent way to invest in an explicit industry while spreading your investment over several stocks.

Money market funds
Money market funds—which invest in various debt securities with short maturities and very low risk—are often the cash option connected with a brokerage account and offered as the same in many 401(k) plans. The return on money invested in the fund is based on the composite interest rate of the underlying investments. Money market mutual funds are considered very safe but should not be confused with money market savings accounts offered by federally insured banks and credit unions.

Balanced funds
These types of mutual funds follow a balanced allocation generally split between stocks and bonds (e.g., 60% stocks and 40% bonds). Balanced funds can follow a balanced index or be actively managed.

Target date funds
Target date funds are managed to conform with a predetermined retirement date equivalent to the fund target date. Over time, these will reduce the fund’s allocation to equities until it plateaus into what is referred to as a “glide path” that levels out the distribution into the fund holder’s target retirement years.

Mutual fund pros and cons

As with any investment, mutual funds have their pluses and minuses. Some benefits include:

·      Diversification. Mutual funds hold several different securities inside of the fund. Although these stocks or bonds may follow a similar investing style or objective, owning various securities inside of the fund provides a level of instant diversification.

·      Easy to buy and sell. Mutual funds, which can be traded on various broker platforms, comprise a large portion of the investment menu with most 401(k) plans.

·      Professionally managed. Mutual funds provide investors with professional assistance via active management or in simply helping the fund obey a passive indexing strategy.

·      Reinvestment of dividends and capital gains. It’s easy to reinvest mutual fund distributions such as dividends and capital gains into additional fund shares, which can help grow your position in the fund over time.

On the flip side, cons include:

·      Fees and other expenses. While many low-cost mutual funds are available in the market, some may carry higher expense ratios or also require an upfront sales charge (load fund) to purchase shares. Unfortunately, mutual fund expenses can drain potential returns for investors.

·      Large cash reserves. Some mutual funds may find themselves experiencing periods of significant cash redemptions and the subsequent need to have large amounts of cash on hand to satisfy the same. Excessive cash reserves can diminish fund returns.

·      No control over taxable distributions. Mutual funds can make distributions at any point during the year in the form of interest, dividends, or capital gains: meaning that if the fund is held in a taxable account, you might find yourself with some unplanned taxable income.

Mutual funds versus ETFs

Both mutual funds and Exchange-Traded Funds (ETFs) are essentially pooled funds that hold a variety of securities (e.g., stocks, bonds, etc.). Both are also professionally managed, either actively or passively. Nevertheless, there are some differences between mutual funds and ETFs:

·      Mutual funds are bought or sold at the end of the trading day, with the transaction generally settling the following business day. ETFs, meanwhile, trade like individual stocks during market hours.

·      While ETFs technically don’t require a minimum investment, they must be purchased as whole shares: meaning that if a share costs $400 and you only want to invest $200, for example, you can’t purchase that particular ETF. Mutual funds do often call for a minimum investment (although typically low), and it’s common to own fractional shares.

·      By nature, ETFs reflect a more tax-sensitive structure that often makes them more tax-efficient than comparable mutual funds.

·      ETFs are often passively managed, though active ETFs are becoming more popular over time.

Keep in mind that mutual funds and ETFs are not mutually exclusive for investors looking to build their portfolios. You can certainly use both types of investments alongside others—such as individual stocks, bonds, and REITs—as building blocks for a diversified portfolio.

In sum: what to know about mutual fund investments

Mutual funds offer an easy way to invest in various asset classes and strategies. However, it’s important to fully understand fund objectives, the corresponding strategy, and all expenses associated with the fund before committing to this investment.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business. 
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.