Mutual funds are a popular option for many investors. That’s because they easily provide a diverse portfolio that can be held onto to generate a significant return on investment in the long-term. Mutual funds have pros and cons depending on the investor and come in a variety of forms. Like any investment, it’s important to do your research before making a commitment.
What is a mutual fund?
A mutual fund is a portfolio of stocks, bonds, money market accounts, and other investments that are managed by financial professionals. A mutual fund provides investors with the opportunity to functionally invest in many different companies with a single purchase. Investing in a diverse portfolio can make you a more resilient investor because you don’t have all your eggs in one basket. For these reasons, mutual funds are popular choices for investing in 401(k)s, Roth IRAs, and other retirement investment accounts.
How do mutual funds work?
When the value of your mutual fund goes up, you make money. The money you make can then be reinvested into the mutual fund so that you have even more shares. When those shares make more money, you can reinvest again so that you get a greater share of the profit. This process can continue up to the point when you decide to sell your shares.
What should I consider before buying a mutual fund?
Before making your investment you should make sure you’re comfortable with investing in the long-term. This could mean not touching it for five years or more. You’ll also need to find an account you can afford to invest in. Aside from fees, some accounts have minimum investments that range in scope from zero to $3,000. You’ll also have to take your own age into consideration since the closer you are to retirement age the lower your risk tolerance.
What types of mutual funds exist?
Mutual funds are categorized based on the nature of their investment. Here’s a quick overview.
Money market funds
Money market funds invest in short-term bonds issued by governments or corporations. Bonds are small loans that allow investors to make a profit off interest payments. Money market funds are low risk because the can only make high-quality investments.
Bond funds
Bond funds come with greater risk because they generally seek a greater reward. That said, the risk and rewards can vary drastically from bond to bond. The fund that works best for you will depend on your goals and the investments you’re able to make given your economic situation.
Stock funds
Stock funds invest in companies. Here are some examples:
- Growth funds: These focus on stocks that show potential for a high return on investment as opposed to dividend payouts. A dividend is a portion of a company’s profits owed to investors paid on a regular basis.
- Income Funds: These funds generate their profits from regular dividend payments.
- Index Funds: These funds mimic the performance of particular indices such as the Dow Jones Industrial Average and the S&P 500.
Target-date funds
Using a mix of stocks, bonds, and investments, target-date funds shift in accordance with the fund’s overarching goals. Known as lifecycle funds, these investments are designed to mature by particular retirement dates.
What are the common mutual fund terms?
Mutual funds come with significant fees by virtue of the fact that they’re managed by professionals. Skilled managers don’t exist in a vacuum and their services require an infrastructure that facilitates maintenance as well as advertising fees to promote their expertise.
Expense ratio
The expense ratio is how much you pay just to invest your money into a mutual fund in the first place. It covers administrative costs and provides mutual fund employees with their income. These fees can add up considerably, so it’s important to always be aware of the expense ratios across your investments. If you invest $20,000 and leave it in the same fund for 30 years, you could end up with $120,370 given the right circumstances. Depending on the expense ratio, however, you could end up spending tens of thousands of dollars in fees.
12b-1 Fee
The 12b-1 fee is the fee that covers the cost of advertising the mutual fund.
Front-end load
The front-end load is a fee you pay just for putting money into your account. This can be a significant chunk of cash. It’s not uncommon for a front end load of $20,000 to be $500 off the bat. That means your actual investment is going to be $19,500 rather than $20,000.
Back-end load
A back-end load is basically paying the front-end load when you make your withdrawal as opposed to when you make your deposit. You’re highly unlikely to pay both. The front-end and back-end load actually end up being the same amount since, for example, 2.5% upfront is the same as 2.5% at the end, once the profits are removed.
Deferred load
A deferred load is what you get when you take your calculated front-end load and pay it off when you sell your investment in the fund. The advantage of a deferred load is that it’s potentially a smaller figure than what your back-end load would be.
What are the benefits of mutual funds?
There are a few reasons that make mutual funds an attractive option for investors.
Instant diversification
When you invest in a mutual fund you’re able to invest in multiple assets with a single purchase. This diversification makes you a more resilient investor by virtue of the fact that all your eggs are no longer in one basket.
Time savings
Not only do you build a diverse portfolio with a single transaction, but you also save time since the mutual fund is managed by professionals.
Potential outperformance
Since mutual funds are a business, the people managing your funds want you to beat the market so that they can attract more potential investors and have a greater pool of resources to work with. Your win is their win.
What are the drawbacks of mutual funds?
The pros of mutual funds must be weighed against their cons.
Fees
All the work that it takes to maintain mutual funds doesn’t pay for itself. For this reason, mutual funds often come bundled with fees that are greater than that of many other forms of investment. The question becomes, then, “Do you think the potential profit is worth the cost?”
Historical underperformance
Some, but not all, mutual funds over-perform. That said, more than a large percentage of mutual funds have fallen short of their stated goals in the past 15 years. That means, unfortunately, that too many investors end up paying more in fees than other forms of investment only to lose to the market. For this reason, some experts propose investing in index funds, which have lower fees but can tend to outperform mutual funds in some cases.
Tax inefficiency
Managing a mutual fund entails buying and selling stocks with regular frequency. This creates a taxable event, which means you now have to deal with capital gains taxes, which can eat away at your profits. Unless you’re working with a tax-advantaged account, you’re going to have to pay taxes on your investment every year.
What are the best funds for beginners?
If you’re just starting out, you want a mutual fund that’s not going to scare you away. Here are two ways to play it safe.
No-Load funds
A no-load fund is one that doesn’t charge a front, back, or deferred load.
S&P 500 index funds
If you’re a long term investor, you can always invest in an S&P 500 index fund. This will allow you to invest in hundreds of the most successful companies with a single purchase. If you want further diversity in your investment portfolio you can always seek out other opportunities down the line.
How to invest in mutual funds the right way
There’s a right way and a wrong way to invest your money. Generally speaking, you want to look before you leap.
Define your objectives
Before you start putting your money to work, you’ll want to know what you are working toward and by when you’d like to reach your target milestone. This is known as your investment objective. Consider the following:
- For what milestone are you investing?
- For how long are you able to invest?
- How much risk can you take on over the course of your investment?
- Do you want the amount of money you have to stay the same or do you want more of it?
Define your time horizon
Historically, the stock market trends upwards. Over the course of days, weeks, months, and even years the market is volatile, but once you start looking at decades you’ll see a consistent upward trend. For this reason, investing in the stock market is a popular strategy for people who are saving for retirement. Additionally, the stock market tends to provide an above-average return for those who wait. But since the upward trend is over a greater period of time, many investment professionals don’t advise short term forays into the market. Some say less than three years isn’t even worth it.
Reduce fees
As a best practice, try not to pay more than 1% of your investment in fees on a yearly basis (not counting expense ratios and sales loads). At some point, the profit you make won’t be worth the fees, and you want to make sure you never reach that point.
Evaluate historical returns
Look to a fund’s performance over the past 5, 10, or 15 years so you can get a sense of how the fund performs during times of economic boom and bust. If it has underperformed or has not even been operating, move on to another option. You’ll also want to see how the fees compare to the profit your fund brings in to make sure the fund merits your investment dollars.
Seek lower fund turnover
The portfolio turnover is the rate at which a fund buys and sells stocks. The way you calculate the portfolio turnover is by dividing the number of stocks bought or sold (whichever is smaller, although the numbers tend to be the same) by the fund’s Net Asset Value (NAV), which is the fund’s value minus its liabilities. The figure is written as a percentage.
If your fund’s portfolio turnover is 75%, that means three-fourths of its investments were replaced over the course of the past year. This high figure means the stocks aren’t held for long before being sold, which in turn means a greater tax liability. Remember, the stock market has a historic upward trend, so holding onto a stock for a greater period of time means that the investment strategy is optimized for the long-term.
In general, you’ll want your fund to have a turnover rate of no greater than 20%. That’s because managers who have a high turnover tend to underperform. In fact, to go the extra mile, you can investigate more than just the turnover rate: you can study the career, philosophy, and stock-picking record of the investor.
Invest in the mutual fund
Once you’ve done your due diligence, it’s time to make your purchase. An online brokerage firm will do, and you’ll pay the price of the account as it appears at the close of the day.
Bottom line
Pros and cons aside, a mutual fund is a great way to make an investment if you’re willing to go the distance and stick it out long-term. This is the case with most passive stock market investments. Pay attention to fees and expense ratios, and do your homework to make informed choices about which mutual funds are the right investment for your objectives.