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 1. The Best Guide to Mutual Funds
 2. Funds
 3. Investing
 4. Money
 5. Home


WHAT ARE MUTUAL FUNDS? THE ULTIMATE GUIDE

From how they work to how to invest, this guide will teach you all you need to
know about mutual funds.

By Paulina Likos and Coryanne Hicks
|
April 30, 2021
By Paulina Likos and Coryanne Hicks
|
April 30, 2021, at 2:30 p.m.
Save
More

The Best Guide to Mutual Funds

More

Instant diversification and access to professional management are a couple of
the top benefits mutual funds offer investors.Getty Images

If investing products were desserts, mutual funds would be the mixed berry pie.
Like that pie, a mutual fund is a collection of different ingredients – in this
case, different types of investments such as stocks and bonds – held within the
crust of the fund portfolio. When you buy a share of a mutual fund, you're
essentially buying a slice of that pie.




THE BEST VANGUARD MONEY MARKET FUNDS

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Matt Whittaker and Barbara FriedbergMarch 25, 2021





Each mutual fund slice is a prorated share of all the investments that make up
the fund's pie. So if the fund is 6% Apple (ticker: AAPL) and 3% Coca-Cola Co.
(KO), your slice will also be 6% Apple and 3% Coca-Cola.



You don't own the individual ingredients or underlying investments that make up
your mutual fund slice, but rather a share of the entire pie. In other words, if
you purchase a share of a fund that invests in Apple and Coca-Cola, you don't
own individual stocks of Apple and Coca-Cola themselves but rather a share of
the fund.

If you're interested in learning more about investing in mutual funds, this
ultimate guide covers the most important things to know:

 * What is a mutual fund?
 * What are different types of mutual funds?
 * Why should you invest in mutual funds?
 * Should you invest in passive or active mutual funds?
 * What fees do mutual funds have?
 * How are mutual funds taxed?
 * How do you choose a mutual fund?
 * How do you buy mutual funds?
 * Should you buy exchange-traded funds or mutual funds?
 * How do you sell mutual funds?



[ 

Read:

Sign up for stock news with our Invested newsletter. ]




WHAT IS A MUTUAL FUND?



A mutual fund is a company that pools investors' money together to invest in a
wide range of different securities. The collection of holdings that make up the
mutual fund is called the portfolio.



"A mutual fund can give investors exposure to many different asset classes and
companies, including – but not limited to – stocks and bonds, at a lower buy-in
cost than if they were to have bought shares of common stock in each of those
companies," says Jordan Sowhangar, a certified financial planner and vice
president and wealth advisor at Girard.



The mutual fund company hires a fund manager who will invest according to the
fund's investment objective. For example, a long-term bond fund may have an
investment objective of generating income for its shareholders. Meanwhile, a
large-cap growth mutual fund may seek capital appreciation.



Sowhangar recommends investors review the fund's prospectus to know its true
investment objective and, more importantly, to determine the purpose of a
particular fund in your overall investment portfolio. Ask yourself: "What role
does this fund play in the portfolio?" Sowhangar says.

"The investor essentially needs to make sure that the investment objective of
the fund aligns with what the role of the fund should be to them," she explains.

The investment objective dictates the types of investments the fund manager
selects. With the bond fund, for example, that manager probably invests
primarily in longer-term-maturity bonds, while the large-cap growth manager
invests primarily in large-capitalization companies.

The mutual fund's investment strategy can be narrow or broad in its focus
depending on your target market.

"The portfolio could be an aggregate market allocation to capture all stocks or
bonds of the world, region of the globe, or even segment or specific theme in
the economy," says Brian Vendig, president, at MJP Wealth Advisors, in Westport,
Connecticut.

Vendig points to some examples like the Vanguard Dividend Growth Fund (VDIGX),
the Fidelity 500 Index Fund (FXAIX), the Pimco Income Fund (PIMIX) or the T.
Rowe Price Blue Chip Growth (TBCIX).

A fund may invest outside of its primary asset class to meet its objective. For
example, the long-term bond fund may invest 80% in long-term bonds and 20% in
shorter-term bonds or other asset classes. This latitude can be a good thing
because it allows a fund to be more dynamic. But it's also something to watch
out for, as it can lead to overlapping on funds



A fund's investment strategy will detail the degree to which a fund manager may
deviate from the core asset class. The investment objective and investment
strategy appear in the fund's prospectus, a legal document fund providers file
with the U.S. Securities and Exchange Commission and give to all new investors.


WHAT ARE THE DIFFERENT TYPES OF MUTUAL FUNDS?



With thousands of mutual funds to choose from, whatever your investment tastes
may be, chances are there's a fund flavor to match. But all this selection can
make it even harder to find the best mutual fund for you.

A good place to start is with the fundamentals. All mutual funds fall into one
of six fundamental categories based on what they invest in:

 * Stock funds invest primarily in stocks.
 * Bond funds invest primarily in bonds and other sources of fixed income.
 * Asset allocation funds invest in both stocks and bonds.
 * Money market funds invest in liquid, short-term bonds intending to give
   investors a cash alternative.
 * Commodity funds invest in commodity-related companies, such as energy or
   mining companies.
 * Alternative funds invest in alternative assets outside the stock-bond
   spectrum and often use complex trading strategies.

Mutual funds typically specialize in a particular area within their broader
category, such as long-term bonds or international stocks.



Balanced funds are a type of asset allocation fund that invests in a balance of
stocks and bonds, commonly 60% stocks and 40% bonds. Other asset allocation
funds also invest in different ratios of stocks to bonds, such as 80% stocks to
20% bonds or a 50/50 split, but they're not considered balanced funds. The
allocation doesn't change over time. So a 50/50 fund will always be 50% stocks
and 50% bonds.

Target-date funds, also called life cycle funds, on the other hand, change their
allocation depending on how close they are to their target date. A target-date
fund begins by investing in assets with high potential returns and then
gradually becomes more conservative as the target date nears.

Most target-date funds start out investing primarily in stocks. As the target
date nears, the fund increases its allocation to fixed income to reduce its risk
level. Although conventionally thought of as retirement products, target-date
funds can be used to plan for any financial goal with a set time frame.





[ 

SEE:

6 Mutual Funds and ETFs to Buy With Your Tax Refund. ]




WHY SHOULD YOU INVEST IN MUTUAL FUNDS?



Instant diversification. A mutual fund may invest in hundreds or even thousands
of stocks and bonds, also known as securities. One advantage of mutual funds is
that they help reduce investment risk through their inherent diversification.

"By rule, a mutual fund is required to be diversified such that the economic
failure of a single company does not implode a portfolio," says Mike McKeigue,
managing director and head of business development at TortoiseEcofin.

Instead of trying to put together your own diversified portfolio of stocks and
bonds, you can buy shares in a mutual fund and gain instant exposure to hundreds
or thousands of securities. Because each share is prorated across all of the
fund's holdings, every share is diversified.



Low minimum investment requirements. While most mutual funds have minimum
investment requirements, they tend to be low – about $1,000 to $2,500. Some
funds have lower minimums or will waive them for investors who buy shares within
an employer-sponsored retirement plan or sign up for the fund's automatic
investment plan.

Professional management. Another benefit of mutual funds is having access to
professional management through the fund manager. The degree to which the
manager makes those decisions depends on whether the fund is actively or
passively managed.


SHOULD YOU INVEST IN PASSIVE OR ACTIVE MUTUAL FUNDS?



Actively managed funds have a portfolio manager who actively selects which
investments to buy and sell to outperform some underlying benchmark, such as a
market index.

Comparatively, a passive mutual fund simply aims to match its benchmark, not
outperform it. The fund's sole objective is to mirror the performance of the
index it tracks by holding the same investments in roughly the same proportion
as the index. A passive fund manager doesn't actively select stocks or bonds to
buy and sell, which is why passive funds tend to have lower expense ratios than
actively managed funds.




WHAT FEES DO MUTUAL FUND HAVE?



Mutual funds can have a few different fees. The most recognized mutual fund fee
is the expense ratio.

An expense ratio is an annual fee that funds charge shareholders. It's expressed
as a percentage of the assets under management and is deducted from the fund
each year to cover its costs.

The expense ratio is used to cover those maintenance costs of the fund. Because
the expense ratio is deducted from a fund's earnings, it reduces the return
shareholders receive.

"Do not choose your mutual fund based on the fee," says Jim Pratt-Heaney,
founding partner at Coastal Bridge Advisors. Rather, Pratt-Heaney says you
should look beyond the management fee and see what the total fee is because
oftentimes funds tag on hidden charges.



"Find out how the fee compares to other funds in the asset class, and if out of
line, find out why. A high fee for a fund that has better performance can be
worth it," he says.

Average expense ratios for equity mutual fund was about 0.5% in 2020, according
to the Investment Company Institute, but specialty or international funds can be
more expensive.

Whether you choose to invest in an active or passive mutual fund depends on your
preference and philosophy. If you believe a manager can outperform the market,
you may be willing to pay the higher cost of an active fund. If you don't
believe it's possible to reliably beat the market, or you are more concerned
with keeping costs low, a passive index fund may be better.



Another mutual fund fee you may encounter is a sales charge or sales load.
Unlike the expense ratio, sales loads are not recurring expenses. Instead, you
pay it when you buy (a front-end sales load) or sell (a back-end sales load) the
fund.

Not all mutual funds have a sales load charge. In general, it's best to avoid
them by choosing no-load mutual funds.

Jan Blakeley Holman, director of advisor education at Thornburg Investment
Management, based in Santa Fe, New Mexico, says it's important for investors to
compare expense ratios between two similar funds that follow the same benchmark.

"When it comes to comparing actively managed funds that have the same investment
objectives or goals and appear to invest in the same types of securities, it's
important to dig further to determine whether there are other key reasons for
expense ratio differences," she says.


HOW ARE MUTUAL FUNDS TAXED?



Mutual funds are less tax-efficient than ETFs because investors buy and sell
shares through the fund manager. This forces the manager to do more buying and
selling within the fund. Since mutual funds are required to distribute capital
gains to shareholders, this can create an unexpected tax bill for investors.

If the capital gains are short-term, meaning the fund manager sold an investment
that the fund had held for less than 12 months, you'll pay ordinary income rates
on the distribution. Long-term capital gains are taxed at the lower capital
gains rate.



If your fund pays a dividend, you'll also be taxed on this. Dividends are taxed
as ordinary income unless certain IRS qualifications are met. Investors must pay
taxes on any dividends received, even if you reinvest those dividends.



To avoid paying taxes on mutual fund distributions in the year they are
received, hold the fund in a tax-deferred account, such as a traditional
individual retirement account or 401(k). With tax-deferred accounts, you won't
pay taxes until you withdraw the money from your account.


HOW DO YOU CHOOSE A MUTUAL FUND?



Your mutual fund choice should depend on why you're investing. Start with your
goals so you don't get distracted by funds that may be good investments but
won't help you reach your goals.

When choosing a mutual fund, McKeigue says investors should consider the four
Ps: people, philosophy, process and performance.

Know who the portfolio managers are and what they bring to the table. Look at
their professional background and experience level to determine if they qualify
to make the fund's management decisions.

Philosophy, McKeigue says, is the portfolio manager's style or investment
approach, process is the methodology used when putting the portfolio together
and performance is how the portfolio has fared in different market conditions.

Sowhangar says another factor to consider is the fund's longevity.

"Although never a guarantee, a fund that has been around for a longer time
period can provide more insight as to how it may perform in certain market
environments in the future, while a new fund has very little historical data to
provide to help you make an informed decision," she says. This context can be
helpful for a "buy and hold" investor.

Once you've found a fund that meets your objectives, it's time to place a trade.




HOW DO YOU BUY MUTUAL FUNDS?



Investing in mutual funds works a little differently from other investments.
Investors buy and sell mutual funds directly through the fund manager. To
purchase shares of a mutual fund, you enter the trade the same way you would for
a stock, but it's the fund manager who receives the request and issues your
shares.



Mutual funds can be purchased on a per-share basis or in a specified dollar
amount. For example, you could buy 100 shares of a fund or you could buy $1,000
of the fund. This is possible because fund managers are willing to sell
fractional shares.

The price per share is determined by the fund's net asset value. NAV is
calculated by adding up the current value of the fund's holdings, subtracting
the fund's expenses and then dividing by the number of shares investors hold, or
shares outstanding. The fund manager calculates a fund's NAV each trading day at
the market close.

Investors receive the next available NAV. So if you place a trade at 11 a.m.,
you'll receive that day's closing NAV. If you place a trade after market close,
you'll get the next day's NAV. You won't know the exact price per share you'll
pay for your mutual fund until the next market close.



[ 

SEE:

7 Best Schwab Mutual Funds for Retirement. ]




SHOULD YOU BUY EXCHANGE-TRADED FUNDS OR MUTUAL FUNDS?



This is one of the key features that set ETFs apart from mutual funds.
Structurally, ETFs and mutual funds are similar: Both are investment companies
pooling investor money to buy a collection of securities according to an
investment objective. Investors own prorated shares of the investments within an
ETF just as they do with a mutual fund.



Where ETFs and mutual funds diverge is how they're traded and priced. ETFs trade
like stocks, meaning investors can buy or sell ETFs on an exchange throughout
the trading day instead of purchasing shares directly through the fund manager.
As a result, ETFs can't be bought in specified dollar amounts because an ETF's
price will fluctuate throughout the day based on investor demand.



This means you don't have to wait until the market closes for the manager to
calculate the NAV to know how much you'll pay for your ETF. You can place a
trade and receive the next available market price. The same holds true when you
decide to sell an ETF.


HOW DO YOU SELL MUTUAL FUNDS?



No matter how great a mutual fund is, you'll eventually need to sell some or all
of your shares. Since mutual fund shares are sold directly back to the mutual
fund company, selling mutual funds is known as "redeeming."

The process for redeeming shares of a mutual fund is the same as buying: You
place a trade for either the specific dollar amount or number of shares you wish
to redeem. In return, the fund manager gives you the cash value of your shares
based on the next available NAV. And the rest, as they say, is history.




Updated on April 30, 2021: This story was published at an earlier date and has
been updated with new information.

Tags: investing, funds, index funds, mutual funds, exchange traded funds, stock
market, Investing Insights, financial literacy, Investing for Retirement,
Target-Date Funds, bonds


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