Takeaways
- Mutual funds are pools of money designed to invest in specific investment strategies.
- A mutual fund share represents an investment in different securities or stocks.
- Mutual funds provide individual investors access to a diversified portfolio.
- Many 401(k) plans offer investments in mutual funds as part of their curated selection.
- Mutual funds have expense ratios, fees, and commissions that affect overall return.
What is a Mutual Fund?
A mutual fund is a pool of capital aggregated by investors who hire a fund manager to take their investment capital and make investments on behalf of the fund. Mutual funds can have different investment objectives based on their investment strategy, and the aggregate investment of the fund is called its portfolio. Investors can buy mutual fund shares at the end of each trading day based on the net asset value (NAV). Each share purchased represents ownership of the fund. Investors in mutual funds hope to accrue capital gains based on the fund assets appreciating and income attributed to the fund
Categories of Mutual Funds
Here are four main types of mutual funds:
1. Equity Funds
Equity funds (or stock funds) are mutual funds that invest exclusively in corporate equities based on the fund’s investment strategy. These funds can concentrate on index investing, growth investing, income investing, socially responsible investing, geographic investing, or industry-specific investing.
Smart Money -> What is a stock?
2. Money Market Funds
Investors like money market mutual funds because they are relatively low-risk investments and highly liquid. Money market mutual funds invest in liquid assets that are short-term in nature, such as cash, cash equivalents, corporate bonds, and federal, state, or local government bonds.
Money market mutual funds typically generate passive income through interest payments. Money market mutual funds are usually temporary investments to park cash for short-term purposes (and produce an investment return) before moving capital to a longer-term investment.
Many money market funds invest in the short-term debt-based instruments listed below:
- U.S. Treasuries
- Certificates of Deposit
- Commercial Paper
- Repurchase Agreements
- Banker Acceptances
Smart Money Tip -> 7 Types of Certificates of Deposit (CDs)
Smart Money Tip -> Best Online Stock Brokerage Accounts
3. Bond Funds
Bond funds offer investors a more effective way of gaining exposure to various bond securities. Instead of purchasing one bond, the invested pool of capital gains exposure to several bond securities based on the fund's mandate. Bond mutual funds can be very niche in concentration, for example, exclusively maximizing exposure to high-yielding corporate bonds, also known as junk bonds.
4. Target Date Funds
Target date funds, sometimes called lifecycle funds, are designed to meet an individual’s retirement date. These funds are unique because their mix of stocks, bonds, and other investments gradually shifts with the fund strategy. For instance, a Target Date Fund 2050 will start its investment mix more heavily tilted to riskier assets. As time progresses, the portfolio mix will morph into a more conservative allocation to preserve the capital in the fund for 2050.
Smart Money Tip -> What is an Exchange Traded Fund (ETF)?
Advantages of Mutual Funds
Now that we have covered the main categories of mutual funds, here are four reasons mutual funds are popular among investors:
1. Diversification
If an individual investor buys one stock or bond, they become tethered to the performance of one stock or bond. With mutual funds, investors pool large amounts of capital to purchase different stocks and bonds. This exposure to many equity and debt securities reduces the total amount of risk because the risk of one stock performing poorly or defaulting on a corporate bond does not affect the portfolio as drastically. Incorporating diversification into your investment strategy can help preserve capital.
2. Affordability
Most mutual funds allow investors to make small initial positions and build upon those initial investments. However, mutual funds vary widely in their minimum investment requirements.
Mutual funds are often categorized based on their share class. Even though the mutual fund may have the same investing objective, professional management team, underlying investments, and investing strategy, the minimum initial investment requirements and expense ratios may vary.
Minimum initial investments can range from $1,000, $3,000, $100,000, or more (for institutional clients) and depend on the share class [1].
Expense ratios, or expenses the mutual fund removes from the fund’s earnings, often include management, administrative, marketing, distribution, or other fees, can also fluctuate based on the share class.
Generally, expense ratios decrease as the minimum initial investment increases. This inverse relationship grants mutual funds economies of scale with more capital to invest on behalf of their shareholder.
3. Liquidity
Mutual funds attract investors who require liquidity as part of their investment strategy. Mutual fund shares are bought and sold at the end of each trading day (based on their NAV). In addition to buying and selling shares, mutual funds offer dividend reinvestment. Dividend reinvestment can be extremely helpful in capturing compound interest for your portfolio and passively growing your investment.
Smart Money -> What Are Dividends?
Smart Money -> What Are Dividend Aristocrats?
4. Professional Management
Investment professionals make up a management team that decides the investments for a mutual fund. This professional management team actively manages the mutual fund holdings. The team consists of portfolio managers (often called “PMs”) and analysts fully dedicated to researching companies, meeting with company management, analyzing the competitive landscape, and determining the best investment for the fund.
Smart Money -> What is Passive Investing?
How Mutual Funds Earn Money
Mutual funds provide advantages such as diversification, professional management, liquidity, and multiple avenues to earn income. Here are three ways mutual funds can earn money:
1. Income Payments
Depending on the category of mutual fund – stocks, bonds, money market, target date fund – the fund will distribute income payments to shareholders in the form of dividends from stocks or interest payments from bonds or money market investments. These income payments are distributed to shareholders (less expense ratio fees) but can also be reinvested into the fund to increase shareholders’ holding over time.
Smart Money -> What is a Dividend Reinvestment Program (DRIP)?
2. Capital Gains Distributions
Mutual funds purchase securities throughout the year. If the mutual fund purchases securities that increase in value during the period of ownership and sell those securities for a gain, the mutual fund will have a capital gain. If they sell those securities at a loss, they will have a capital loss. At the end of the year, capital gains less any capital losses, are distributed to the mutual fund shareholders.
3. Increased Net Asset Value
The market value of a mutual fund’s investments increases over time, corresponding to a rise in the value of the mutual fund shares. This higher NAV per share translates into a higher value for mutual fund shareholders, and if sold, would constitute an investment gain.
Should You Invest in Mutual Funds?
Mutual funds offer various choices regarding investment style, fund management, and areas of investment focus. Mutual funds are great investments for beginner investors who want to learn more about investing and accrue an investment base. With lower minimum investment fees and access to professional management, mutual funds offer a low-cost solution for many investors. Consult with your financial advisor to see if investing in a mutual fund matches your financial goals.
Smart Money -> Retirement 101: How to Start Saving for Retirement
Smart Summary
Mutual funds offer a low-cost solution to actively managed funds. While mutual funds have advantages like diversification, easy access, professional management, and a buffet of investment choices, they also have disadvantages. Mutual funds have a place in many investors’ investment allocations. You can take advantage of mutual fund exposure when constructing your investment portfolio. Carefully crafting your mix of investments is a smart money move.
Frequently Asked Questions
Actively managed funds have portfolio managers who try to outperform benchmarks and peer averages. Passive investing is usually associated with index mutual funds and exchange-traded funds (ETFs) that seek to match the performance of a market benchmark.
You can sell your mutual fund shares whenever you want. There may be tax implications for your holdings when you sell, so review the funds’ policies. You also want to consider redemption and exchange fees.
Mutual fund investments are not tax-advantaged as an investment vehicle. You can invest in mutual funds through tax-advantaged retirement accounts like a 401(k) or Traditional IRA.
[1] Vanguard. At a glance: ETS vs. Mutual Funds. Last Accessed September 6, 2023.
