For decades, mutual funds have been popular investment vehicles. Even with the advent of low-cost ETFs, mutual funds still play a substantial role in the investing universe. (Read about the difference between mutual funds vs ETFs here).
In fact, some types of accounts limit your investment options to mutual funds exclusively. This is typically the case with employer-sponsored retirement plans, like 401(k)s. Mutual funds are a common investment choice for many employers. This is partially due to the inherent spread of risk, which can lower the chances of the employee’s retirement fund crashing overnight.
However, it’s also important to note that there is no “zero risk” investment out there. Even mutual funds carry some risk, as the money still goes into various investment vehicles with no guarantee of generating returns.
This article will provide you with a breakdown of what mutual funds are and why they provide an alternative to some other investments on the market. We will also cover some important considerations to keep in mind as it relates to the popular investment vehicle.
Before we continue, Financial Professional wants to remind you that this article is educational in nature. Any securities or firms named are for illustrative purposes only and do not constitute financial advice. Always do your due diligence and consider your situation – and the help of a licensed financial professional – when making investment decisions.
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A mutual fund is an investment that pools together the money of thousands of investors, thereby lowering the risk for each individual. That money is managed by a fund manager according to a set, specific strategy. We’ll cover some of the different types of mutual funds shortly.
Companies like Vanguard, American Funds, and Fidelity offer these types of funds. These investment companies make their money off of commissions (sales loads) and other fees (12b-1, etc.). All of these fees can be found on the fund’s prospectus or fact sheet. In most cases, you can also find this data through a quick Google search.
As an investor in the mutual fund, you own shares of the fund, just like you would own shares of stock in a publicly traded company. The value of the shares tends to fluctuate with the performance of the underlying investments owned by the mutual fund. If the fund manager selects investments that perform well, the value of your shares will increase, and vice-versa. Other factors like supply and demand may play a role as well.
While there are a lot of different types of mutual funds that you can invest in, they all tend to fall under one of two categories:
Open-end funds are the most common type of mutual funds, as they can offer an unlimited amount of shares at the discretion of the fund. As an investor in an open-end fund, you purchase the shares directly from the mutual fund company and you redeem the shares back to the mutual fund company. When you redeem shares of a mutual fund, you “return” them back to the mutual fund and receive cash for the shares.
Open-end shares only trade at the fund’s Net Asset Value (NAV) at the close of the trading day – in other words, they do not trade like stock. You don’t know the price at which the purchase or redemption executes until the close of the market.
Closed-end fund shares work differently. These types of mutual funds issue a fixed amount of shares, which trade intraday just like stock. Unlike open-end fund shares, which are redeemed back to the mutual fund, closed-end fund shares can only be traded amongst other investors in the secondary market.
Taking it a step further, mutual funds can be classified as active or passive funds.
Managers of active mutual funds are actively placing trades within the fund in an attempt to provide shareholders with higher levels of returns compared to a certain benchmark, like the S&P 500.
Managers of passive mutual funds simply try to mirror the performance of a specific benchmark instead of seeking outperformance. As such, much less trading goes on within the fund (hence the term “passive”).
Active funds tend to be more expensive than passive funds due to the fact that you are paying a manager to attempt to provide you with excess returns (alpha returns). On the other hand, passive funds require much less work. It is not uncommon to see passive funds with very low expense ratios.
The SWPPX mutual fund offered by Charles Schwab is a classic example of a passive fund. This fund is designed to track the performance of the S&P 500 and carries an expense ratio of 0.02%.
Passively-managed funds are typically referred to as “index funds” since they are designed to mirror the performance of specific sectors and/or indices.
While there may be value in owning actively managed funds, especially in niche areas (commodities, sectors, etc.), be very mindful of the fees that are associated with active funds. Over a period of time, fees can substantially eat away at the returns in an investor’s portfolio.
Research has also pointed out that actively managed funds tend to underperform in large part. Many of them fail to keep up with their benchmark as well.
Taking it a step even further, mutual funds can be classified as the following:
That list is not exhaustive. However, it does cover the majority of the different types of funds.
Equity funds invest primarily in stocks. Depending on the strategy of the equity fund, the manager may invest solely in a specific sector (like technology), style (growth vs value) or size (small cap).
There are thousands of equity mutual funds out there. Make sure you are comfortable with the stocks that a fund invests in before purchasing shares.
Fixed income funds invest primarily in bonds. Like equities, there are many different types of bonds. Fixed income funds can invest in bonds that vary in maturity, issuer, credit rating, etc.
Money market funds invest in short term fixed income investments that have similar characteristics to cash. Classic examples of money market investments include CDs and Treasury Bills. These funds are designed to provide investors with principal protection and slightly higher levels of yield compared to traditional cash.
Balanced funds tend to have a mix of the investments that were mentioned above. These may also be referred to as allocation funds since they can range from ultra-conservative to ultra-aggressive in terms of risk.
Alternative funds invest in alternative asset classes like commodities, real estate, etc. These asset classes tend to be non-correlated with the stock market and can provide investors with diversification.
As discussed earlier, mutual funds can also vary in how they charge investors commissions on transactions. Different mutual fund share classes carry different types of commissions (or sales loads).
The most common types of mutual fund shares are:
A Shares carry a “front-end” load. This means that you pay the commission upfront when you purchase the shares. For example, if you purchase $10,000 worth of A Shares that carry a 5% load, you’ll only end up with $9,500 worth of shares due to the commission.
B Shares carry a “back-end” load. This means you pay the commission on the sale (or redemption) of the fund. If you sold $10,000 worth of B shares that carried a 5% load, you would net $9,500 in cash after the commission. B Shares tend to come with contingent deferred sales charges (CDSCs).
C Shares carry a “level” load. This is typically assessed as a level annual management fee that is assessed from the returns of the fund shares. C shares may also carry CDSCs, but they are typically much lower compared to those of B Shares.
No Load shares are becoming much more popular. This class of shares does not assess a load but still may charge other types of fees (like 12b-1 fees, etc.).
Before investing in a mutual fund (or any other investment), you should do your due diligence. Some key areas to research prior to purchasing shares of a fund are:
The good news is that the majority of this information can be found via the fund’s prospectus or fact sheet. By law, funds are required to provide investors with literature that highlights many of these key items. If the fund is publicly traded, you can also find the information via a Google search.
There are also helpful websites that can help you research a fund. Morningstar is well-known for its research. Its website can also provide you with comparisons of similar funds so you are making an educated decision, with all variables considered.
Mutual funds have historically provided investors with several benefits such as:
However, many investors are wary of primarily relying on mutual funds due to the fact that they are not in control of the way the fund’s assets are managed. Depending on the manager’s history, this can raise or lower the investment risk. Also, mutual funds have been known to carry higher fees compared to ETFs and owning individual stocks.
If you are going to use mutual funds in your portfolio, make sure you do an adequate amount of research beforehand. As discussed, many of the items we touched on throughout this article can be found online or via the fund’s prospectus.
As with any type of investment, make sure that you understand how the fund would play a role in your overall strategy. Make sure you educate yourself on the risk(s) that the fund would be exposed to as well.
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