Ryan O’Leary is a writer and former financial services professional. He writes about personal finance for Wealthsimple and his work has been featured by the New York Stock Exchange. Ryan holds a Bachelor's degree in International Business from University College Cork in Ireland.
Do you want to invest your money but also avoid some of the risks that come with picking individual stocks? Mutual funds provide the benefits of a diversified portfolio without the time needed to manage one.
Mutual funds are one of the most common tools investors use to build long-term retirement savings. If you have any type of retirement account — there’s a good chance your portfolio includes mutual funds.
What are mutual funds?
A mutual fund pools money from a set of different investors in order to invest in a managed portfolio of stocks and/or bonds. Unlike the stock market, in which investors purchase shares from one another, mutual fund shares are purchased directly from the fund or a broker who purchases shares for investors.
The price of the mutual fund, also known as its net asset value (NAV), is determined by the total value of the securities in the portfolio, divided by the number of the fund's outstanding shares. This price fluctuates based on the value of the securities held by the portfolio at the end of each business day. One thing to note – mutual fund investors don’t actually own the securities in which the fund invests; they only own shares in the fund itself.
In the case of actively managed mutual funds, the decisions to buy and sell securities are made by one or more portfolio managers, supported by researchers. A portfolio manager's primary goal is to seek out investment opportunities that help enable the fund to outperform its benchmark, which is generally an index such as the S&P 500. One way to tell how well a fund manager is performing is to look at the returns of the fund relative to this benchmark. While it may be tempting to focus on short-term performance when evaluating a fund, most experts will say that it's best to look at longer-term performance, such as 3- and 5-year returns.
How to make money from mutual funds
With all types of investing that you can make money or lose money. Investing in mutual funds is no different. When you invest in a mutual fund, cash or value can increase from three sources:
Dividend payments:Income is earned from dividends on stocks and interest on bonds held in the fund’s portfolio. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution. Funds often give investors a choice to either receive a check for distributions or to reinvest the earnings and get more shares.
Capital gain: When a fund sells a security that has gone up in price, this is a capital gain. When a fund sells a security that has gone down in price, this is a capital loss. Most funds distribute any net capital gains to investors annually.
Net asset value (NAV): If fund holdings increase in price but aren’t sold by the fund manager, the fund's shares increase in price. This is similar to when the price of a stock increases — you don’t receive immediate distributions, but the value of your investment is greater, and you would make money if you decide to sell.
Investors in a mutual fund share equally in losses and gains. If one of your investments within the mutual fund goes bad at least this does not drag down your entire investment portfolio. While investing in mutual funds does help to spread the risk, it doesn't eliminate it. While it's possible you could make money from investing in mutual funds, you could also lose it.
Benefits of a mutual fund
There are two primary benefits to investing in mutual funds:
Diversification: You could say that diversification is one of the most important principles of investing. If a single company fails, and all your money was invested in that one company, then you have lost your money. However, if a single company fails within your portfolio of many companies, then your loss is limited. Mutual funds provide access to a diversified portfolio, without the difficulties of having to purchase and monitor dozens of assets yourself.
Simplicity: Once you find a mutual fund with a good record, you have a relatively small role to play. The professional fund managers can do all the heavy lifting.
Disadvantages of mutual funds
The main disadvantage to mutual funds is that, because the fund is managed, you’ll incur fees no matter how the fund performs. Investors have to pay sales charges, annual fees, and other expenses with no guarantee of results.
Also, some people don’t like the lack of control with a mutual fund; you may not know the exact makeup of the fund’s portfolio and have no control over its purchases. However, this can be a relief to some investors, who simply don’t have the time required to track and manage a large portfolio.
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How do mutual funds work?
Mutual funds are divided along four lines: closed-end and open-ended funds; the latter is subdivided into load and no load.
Closed-end funds: This type of fund has a set number of shares issued to the public through an initial public offering (IPO). These shares trade on the open market. This, combined with the fact that a closed-end fund doesn’t redeem or issue new shares like a normal mutual fund, subjects the fund shares to the laws of supply and demand. As a result, shares of closed-end funds normally trade at a discount to net asset value.
Open-end funds: A majority of mutual funds are open-ended. Basically, this means that the fund does not have a set number of shares. Instead, the fund will issue new shares to an investor based upon the current net asset value and redeem the shares when the investor decides to sell.
Load vs. no load: In mutual fund terms, a load is a sales commission. If a fund charges a load, the investor will pay the sales commission on top of the net asset value of the fund’s shares. No-load funds tend to generate higher returns for investors due to the lower expenses associated with ownership.
Passively managed funds invest according to a set strategy. They try to match the performance of a specific market index and therefore require little investment skill. Since these funds require little management, they will carry lower fees than actively managed funds.
Actively managed funds seek to outperform market indices and carry the potential for greater return than passively managed funds. They also carry higher potential rewards as well as risks.
Fund investors usually pay annual fees for the running of the fund, known as expense ratios, which are based on a small percentage of the total value of the shares. Passively managed funds have lower expense ratios compared to actively managed accounts, as they require fewer financial professionals and other overhead costs.
Paying attention to account minimums and fees can be an effective way to choose among mutual funds.
How to invest in mutual funds
You can purchase through a retirement account, or directly from a fund provider such as Vanguard or Fidelity. Both options, however, can limit your choice of funds.
You’ll have more choices if you open a brokerage account to begin investing. There may be a minimum deposit requirement and some if you want to invest a small sum of money you might be best served to find some providers that offer $0 minimum.
Alternatives to investing in mutual funds
Exchange-traded funds (ETFs)
ETFs are kind of like a mutual fund’s cousin. They both help investors buy large swaths of investments in one fell swoop. And they both often concentrate those investments in a particular sector — be it stocks, bonds or real estate. But they have their differences, the biggest one being the price for entry — it's often lower for ETFs. You can start investing in ETFs by trading yourself or opening an account with an investment provider that will create an investment portfolio for you. Exchange traded funds generally have lower fees than active mutual funds because you're not paying people to actively manage your money. ETFs are traded like a stock, meaning they can be bought and sold throughout the trading day.
A robo-advisor is a service that uses algorithms to do the job of wealth managers who tinker with your investments over time. Many mutual funds require initial investment minimums that can be as high as a few thousand dollars. Most robo-advisors have low account minimums or no account minimum at all. This makes them much more small-investor-friendly. They're equally as valuable for large investors as generally, they have low fees. Fees eat into the amount of money you potentially make from investing and so you should seek to reduce them as much as possible. While actively managed mutual funds try to beat the market, robo-advisors generally use index ETFs that aim to track the market.
Unit-investment trusts (UITs)
UITs resemble mutual funds in that each unit of the trust represents a portion of each security that is held within the portfolio. They are more tax-efficient than actively managed funds, although they may post substantial gains or losses when the trust matures.
Closed-end mutual funds These funds have a limited number of shares that can be issued to investors. Once all of the shares are sold, the fund is closed to new investors and the shares begin trading in the secondary market.
Variable annuity sub-accounts These are essentially clones of taxable retail funds, but must be treated and reported as separate securities for regulatory reasons. Variable subaccounts have most of the same disadvantages as open-ended funds except that they don’t post capital gains distributions.
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