When you’re investing, diversification is the name of the game. But if you’re not into picking individual stocks, how do you get a diverse basket of investments? Enter the mutual fund. A mutual fund can give you access to an entire portfolio of stocks or bonds in one transaction.
While mutual funds tend to be a more turnkey solution than buying individual stocks or bonds yourself, there are still some things you should know about them.
What is a mutual fund?
A mutual fund pools the investment dollars of a group of shareholders and is professionally managed, buying stocks, bonds or other investments based on the mutual fund’s investment objective. Mutual funds take the guesswork out of building a diverse portfolio one stock at a time. What’s more, mutual funds don’t just buy stocks. They come in all shapes and flavors.
Odds are, if you want to add broad market exposure or narrow to a particular corner of the market, there are several mutual funds to choose from. A mutual fund’s performance history, style, benchmark and other key information is all spelled out in a document known as the prospectus.
Some of the most popular mutual fund categories include:
- By company size (Small Cap, Mid Cap, Large Cap)
- By sector or style (Industrials, Value stocks, ESG)
- By geography (U.S., China, International Developed Emerging Markets, Asia Pacific)
- By type (Corporate, High-Yield, Municipal)
- By geography (state-specific municipal bonds, U.S. Treasury bonds, emerging-market bonds)
In addition, you can buy funds that allocate among several asset classes, such as stocks, bonds or other investments. Examples of these types of mutual funds include asset allocation funds or target-date funds, which change your allocation over time, typically reducing risk as you approach the target date.
There are also mutual funds that buy other types of investments, such as commodities or real estate.
Passive vs. active
In addition to differences in the types of investments that a fund may hold, there are also differences in how they are managed. A passive fund simply mirrors a benchmark — typically an index like the S&P 500 or NASDAQ. Passive fund fees are typically lower. However, these funds are unlikely to outperform the index they track because they attempt to mirror that very index and have underlying expenses.
However, in an active fund, a manager researches and picks stocks based on a proprietary formula and investment approach. While fees are typically higher than a passive fund, over time, active managers attempt to add value in the form of better returns by making investment decisions that differ from its benchmark. Of course, active managers could also underperform a passive fund or benchmark.
How a mutual fund works
One key difference between a mutual fund and other types of investments is how it trades or, more specifically, how the price of the fund is set. Unlike typical investments that go up and down during trading hours, most mutual funds are priced and traded once daily.
A mutual fund is priced once a day (after the market closes), and the daily net asset value (price) is derived from the value of the securities held in the fund and shares outstanding. Your investment then changes in value along with the NAV. Mutual funds also often pay dividends (quarterly or monthly income) and capital gain distributions (resulting from the sale of investments within the fund that were sold at a profit).
Mutual fund fees
With any investment, there is typically a cost associated with it. When it comes to mutual funds, there may be a few.
Loads: When you buy or sell individual mutual funds, you may pay a load fee. These are commonly front-end loads. With a front load, you pay a percentage of the amount that you invest up front.
Expense Ratio: This is a fee charged by the managers for annual administration and operating costs.
The next step
Mutual funds offer an easy way to diversify your portfolio to work toward achieving your financial goals without the need to research dozens of individual investments and keep a constant eye on the markets.
Your financial professional can help you navigate the universe of mutual funds and other related investments and show you how they work within a broader financial plan.
No investment strategy can guarantee a profit or protect against a loss.