Guide to investing in mutual funds
Millions of Americans use mutual funds to achieve their financial goals, but you may not be sure exactly what they are or how to start investing in them. Like many financial products, they can be intimidating at first, but mutual funds are fairly straightforward with a little help.
What is a mutual fund?
A mutual fund is a pool of money collected from investors which is then invested in securities such as stocks or bonds. Each share of the fund represents a proportional interest in the fund’s portfolio, so the more shares you own, the greater your interest in the fund.
If a fund has 5% of its portfolio in Apple and 2% in Home Depot, for example, your share of the fund will hold the same shares in the same proportions.
There are thousands of mutual funds that allow you to invest in a variety of ways. You can find funds that invest in a diverse group of large companies, small businesses, specific geographies, or even certain sectors of the economy.
Who should invest in a mutual fund?
Mutual funds can be meaningful to many different people at different times in their investing lives. But it’s important to remember that it’s not about the mutual fund itself, but rather what goes on in the mutual fund that will determine if investing makes sense to you.
These funds can hold assets such as bonds, stocks, commodities or a combination of several asset classes. You’ll want to do your research before investing in a fund and make sure you understand the risk of the fund’s underlying assets.
Mutual funds are good options for new investors as well as more experienced investors. Both types of investors will benefit from the diversification benefits of mutual funds, and experienced investors can find funds that target specific areas that they believe are ripe for growth.
Active vs passive mutual funds
One of the biggest distinctions between different mutual funds is whether they pursue an active or passive investment strategy. The difference will determine how the fund invests and can ultimately have a big impact on the returns you earn as an investor.
Active mutual funds
Active funds are managed by professional investors with the aim of outperforming a market index, such as the S&P 500 index. For an active equity fund, the fund manager and a team of analysts will work to identify stocks. to hold and in what quantities to obtain the best returns. Likewise, active bond funds will attempt to beat bond indices through superior management.
But it’s not as easy as it looks, and actively managed funds often fail to match the performance of the index they’re trying to beat in the first place. On top of that, active funds come with a higher fee (often around 1% of fund assets) to pay for professional management, so returns for investors are further reduced by these types of costs.
Passive mutual funds
Passive mutual funds are managed to track the performance of a market index. They don’t need an expensive investment team to manage the portfolio because they don’t try to identify the top performers, they just try to match the index. This allows passive funds to charge very low fees and sometimes no fees, leaving more of the return to investors in the fund.
Passive funds may seem simple and even a little boring, but they’ve always beaten actively managed funds over long periods of time. There will always be a few active funds that will outperform their benchmarks over short periods of time, but very few will do so consistently over the long term.
What are the different types of mutual funds?
There are many different mutual funds available to investors and it can be confusing for inexperienced investors to go through them all. Let’s take a look at some of the more popular types of funds.
- Equity funds: These funds invest in stocks of companies, but may also pursue different strategies from one fund to another. Some funds focus on companies that pay dividends and are well established, while others focus more on growth and the potential for price appreciation. Still others focus on specific industries, sectors or geographic areas.
- Bond funds: These funds invest in various forms of debt and their risk profiles can vary significantly from fund to fund. Some will invest in relatively safe bonds issued by governments, while others will invest in so-called “junk” bonds which offer higher potential returns. Make sure you read the prospectus before investing to make sure you understand the risks being taken.
- Money market funds: These funds tend to be low risk and generate a lower return than a normal savings account. Money market funds invest in high quality, short-term debt securities issued by companies and governments.
- Index funds: These funds have gained popularity in recent years due to their simplicity and low cost structure. Index funds track the performance of an index such as the S&P 500 and are generally able to keep costs low. Studies have shown that this passive approach outperforms active management over long periods of time in most cases.
How to choose a mutual fund
Choosing which fund to invest in can be daunting when you consider all of the different options. The first thing to consider is whether a fund’s investment objectives match your long-term financial plan. For first-time investors at the start of their careers, investing in a low-cost S&P 500 index fund is probably an attractive option.
For more experienced investors or for people looking to invest in an actively managed fund, more research may be needed. You will want to understand the overall approach and investment philosophy of a fund and who the portfolio managers will be making the investment decisions on your behalf. Ultimately, a fund’s performance is what matters to you as an investor, so try to understand the drivers of a fund’s long-term performance and whether this is likely to continue in the future. to come up.
You will also want to consider the costs associated with buying stocks in a fund. Remember that if two funds have the same investment return, the one with the lower fees will leave their investors better off.
How to buy mutual funds
Mutual funds can be purchased through online brokers or through the fund manager himself. But there are some differences between the way mutual funds trade and the way a stock or ETF trades.
Mutual funds are valued at the end of each trading day based on their net asset value, or net asset value. Net asset value is calculated by adding the value of the fund’s holdings, subtracting expenses and dividing by the number of shares outstanding. When making a purchase, you will receive the next NAV, so if you place an order after the market has closed, you will receive the next day’s closing NAV as the price.
Most mutual funds have a minimum investment of a few thousand dollars and you can choose to buy a certain dollar amount of a fund or a specific number of stocks.
Why should you invest in a mutual fund?
You should consider investing in a mutual fund if the fund’s objective matches your investment needs. A fund that invests primarily in stocks won’t be suitable if you think you will need money in a year from now, while a bond fund probably won’t be the best option if you are looking for a fund to help you. achieve your long-term retirement goals in the distant future.
Make sure you read a fund’s prospectus before investing to understand how your money will be invested and if it makes sense for your own financial goals.
How Do Mutual Funds Make You Money?
Mutual funds make money by investing in securities on your behalf. The fund can only do as well as the underlying securities it holds. Income and appreciation are generally the two ways to make money in securities.
Income comes in the form of interest or dividend payments which are then passed on to you as a fund investor. The appreciation may be reflected in the net asset value per share of the fund or distributed to investors in the form of capital gains, less any losses.
Watch out for these fees
One of the most important things to consider when investing in mutual funds is the fees you will need to pay. You can find this information in the fund prospectus, and while it may not seem like much, the costs do add up over time.
The funds may charge a fee for a number of costs related to the expenses of operating the fund. The management fee pays the managers and the investment advisor of the fund, while the 12b-1 fee covers the costs of marketing and selling the fund. Other expenses include legal, accounting and miscellaneous administrative costs.
You can also come across what are called funds with and without fees. Charges, or commissions, are charged by certain funds and paid to dealers when buying or selling shares of the fund. Commissions are usually calculated as a percentage of your overall investment. Funds that do not charge this commission are called no-load funds.
An annual fee of just 1% can drastically reduce your returns over a decades-long investment life and disrupt your retirement plans. While no one knows how well an investment can perform, everyone can be sure how much fees they will pay. In many cases, you can buy the same type of fund, such as an S&P 500 index fund, with much less expense.
Taxes are also fees, so it’s a good idea to hold mutual funds that are part of your long-term plan in a tax-efficient account such as an IRA.
At the end of the line
Mutual funds can be a great way to invest in a diversified portfolio of securities for a relatively low minimum investment. Make sure you read a fund’s prospectus before investing and understand the risks involved. Consider investing in index funds as a way to lower your costs so that more of the return ends up in your pocket.