Introduction to Mutual Funds

More than half of the households in America today invest in mutual funds. They have become such an important part of our lives that when many people say that they are “investing their money,” they mean that they have purchased mutual funds. But, unfortunately, that is where many people’s understanding of mutual funds ends.

Key takeaways

Take control of your money, optimize your spending and grow your savings automatically

• A mutual fund pools money from many investors to buy a diversified collection of stocks and bonds, giving small investors access to professionally managed portfolios.
• Investors earn returns two ways: dividend distributions and capital gains as the value of fund shares rises.
• The three basic fund types are equity funds, fixed-income funds, and money market funds – everything else is a variation built on these.
• Fees matter more than almost anything else. No-load, low-MER index funds consistently outperform high-fee and load funds after costs.
• Every mutual fund carries risk: higher potential returns come with a higher risk of loss.

What Is a Mutual Fund?

Mutual funds are simply a collection of stocks and bonds. Because the stock market is such a complex system, mutual funds were created as a way for the little guy to invest with the big dogs.

Each investor in the fund owns shares that are valued at the proportion to which they invested into the fund. For example, if a fund is valued at $10 million and there are 10 million shares, each share would be worth $1.

How Do You Make Money From a Mutual Fund?

Since funds are made up of stock and bonds, investors can earn money from investing in the fund in one of two ways. Funds which own stocks that earn dividends pay out a dividend distribution to the fund owners. Or, funds that realize a capital gain increase in value, making each share of the fund more valuable. These shares can then be sold off as a capital gain for the shareholder.

Advantages of Mutual Funds

There are many advantages to using a mutual fund including:

• Having a professional manager to choose the stocks and bonds within the fund.
• Larger funds own hundreds of different stocks, diversifying the portfolio and lowering the impact of poorly performing stocks by averaging out their losses.
• By purchasing large amounts of securities at a single time, transaction costs are significantly lower per trade.
• Similar to stocks, mutual funds allow you to convert your shares to cash at any time.
• Buying mutual funds is as easy as calling your bank or setting up monthly purchase plans of as little as $50 per month.

If you’re weighing mutual funds against other options, it helps to see where they fit in a wider strategy – PocketGuard’s guide to investments for beginners walks through how these pieces work together.

What to Keep in Mind Before Investing

But there are also some things to keep in mind when investing in mutual funds.

• Mutual fund managers are paid for the amount of money that they have under management, usually about 1% of the total value of the fund, not for the performance of their funds. So, if you invest in a $200 million fund and it doesn’t have any earnings, you lose 1% of your money and the fund manager who helped you lose money this year gets $2 million.
• If a fund does very well in one year, people will tend to invest more heavily into it. When this happens, the fund manager may not be able to find good investments for the new money, lowering the performance in the following years.
• Anytime a fund manager sells a security within the fund, a capital-gains tax is triggered. When you are choosing an investment, investors either need to be prepared to deal with the extra paperwork at tax season, invest in tax-sensitive funds, or hold mutual funds in a tax-deferred account such as a 401(k) or IRA.

It is important to realize that, like in our previous example, there is always an element of risk involved in any mutual fund. This means that while you can realize large gains, you can also lose some (or all – although this is virtually impossible) of the money that you initially invest. As a general rule of thumb, the higher the potential return, the higher the risk of loss. If you want a sense of how quickly returns can compound in your favor over time, the Rule of 72 and compound interest is a simple way to estimate it.

The Three Basic Types of Mutual Funds

There are thousands of mutual funds in America — in fact, more than there are individual stocks in the stock market. Every fund is a blend of the 3 basic types of funds.

1. Equity funds (stocks) – This is the largest class of mutual fund and can be further divided up by the investment strategy (value, blend, growth) and the size (small, mid, large) of the companies that the fund will invest into.
2. Fixed-income funds (bonds) – These invest in government and corporate debt and try to provide a low-risk, steady income for investors.
3. Money market funds – Short-term debt instruments, usually treasury bills. These help ensure you never lose your investment, but offer the least opportunity for high growth.

Common Derivative Fund Types

From these basic types of funds come a whole range of derivative funds.

• Balanced funds mix the safety of income funds with the capital appreciation of equity funds into a single fund.
• Global funds invest in companies from other countries anywhere in the world.
• Sector funds target specific sectors of the economy such as financial, technology, health, etc.
• Regional funds focus on a specific geographic area of the world such as Brazil or Asia.
• Socially responsible funds (or ethical funds) only invest in companies that meet certain criteria and allow you to avoid investing in industries such as tobacco, or focus on companies you believe should be supported.
• Index funds replicate the performance of a market index such as the S&P 500 or Dow Jones Industrial Average (DJIA).

The Truth About Mutual Fund Fees

Mutual funds have been criticized for their high fees, and for good reason – a quote from the Securities and Exchange Commission’s website states that “Higher expense funds do not, on average, perform better than lower expense funds.”

The last type of fund, index funds, are becoming very popular with investors as they generally have lower management expense ratios (MER) reaching as low as 0.25%.

The last expense that you need to be very careful to watch is the “load” – otherwise known as “the commission for the salesperson.” Whether it is a front-end or a back-end load, it will usually be about 5% of the value of the money you invest. There’s no reason to pay this. Research has found no link between paying a load and getting better performance – in fact, once fees are counted, the average load fund tends to underperform a comparable no-load fund. Basically, if someone asks you to pay a load, walk away.

Fees inside retirement accounts deserve the same scrutiny – the inside scoop on 401(k) fees shows how small percentages quietly eat into long-term balances.

Putting It All Together

Mutual funds can be a great tool to help you take advantage of the potential growth available through equity markets. By investing in a no-load, index fund with a low MER, the average investor can realize higher long-term returns on their investments while keeping their risk down through a diversified investment strategy. Once you’re comfortable with the basics here, it’s worth reviewing the 10 best investments for starting your investment portfolio to see how mutual funds fit alongside other options.

FAQ

What is a mutual fund in simple terms?

It’s a big shared pot of money. Lots of investors put money in, and the fund uses it to buy a mix of stocks and bonds. You own a slice of that pot based on how much you put in, and a manager decides what to buy.

How do mutual funds make money for investors?

Two ways. Some funds pay you a cut of the dividends their stocks earn. And when the fund’s shares go up in value, you can sell them for more than you paid.

Are mutual funds safe?

They’re safer than betting on a single stock, because your money is spread across many. But they’re not risk-free – the value goes up and down with the market. The bigger the potential reward, the bigger the chance of losing money.

What is a “load,” and should I pay one?

A load is just a sales commission, usually around 5%, that some funds charge when you buy or sell. There’s no proof it gets you better results, so most people are better off skipping it. If someone pushes a load fund, walk away.

What’s the difference between a mutual fund and an index fund?

An index fund is a kind of mutual fund that just copies a market index like the S&P 500 instead of having a manager pick stocks. Because there’s less work behind it, the fees are much lower – which is why they’re so popular.

Where should I keep mutual funds to pay less tax?

Selling investments inside a fund can trigger taxes. To avoid the headache, a lot of people hold their mutual funds in a retirement account like a 401(k) or IRA, where those taxes are put off.