Mutual Funds – A Comprehensive Guide

An infographic that explains what a mutual fund is, types of mutual funds, costs associated with mutual funds, and mutual funds pros and cons.

Mutual funds can be a great investment option for the beginning investor. Investing in stocks can be a lucrative but risky business, especially for someone new to the investment industry. Decisions on how to start the process, what individual stocks to buy, and how to reduce the risk can become extremely overwhelming. Insecurity and lack of time and expertise can prevent people from taking the plunge. Mutual funds can be the solution to their problem. 

What if your investment objective is to invest $10,000 in various stocks and bonds, for a 3 to 5 year period, with average risk exposure and an average return of 10-12 % per year? Of course, you can take the time to do the research required and create an investment portfolio of individual securities with a combined past performance return of about 10 to 12 % per year. However, it would be extremely time-consuming and frustrating. In addition, it would most likely not make you feel very confident that you would reach your financial goals because of your inexperience in this field. 

Would it not be a lot easier and quicker if someone with a lot of expertise and experience had already done that work and you could just buy “it” from them? That is where mutual funds come in. With a single investment, you can invest in hundreds of different stocks or bonds managed by a professional fund manager, making diversification and reducing risk extremely easy.

This article will discuss what mutual funds are, how they work, different types of funds, their advantages and disadvantages, costs involved, and how to invest in them.

What are Mutual Funds?

A mutual fund is a company that is managed by a highly experienced portfolio manager who pools money from various investors to buy and manage a diversified portfolio of securities according to the fund’s investment objective and strategy. Its objective is to minimize risk while maximizing returns at a relatively low cost.

When you invest in a mutual fund, you purchase a share of stock in the fund and become a part-owner in the mutual fund company. This will entitle you to your part of the fund’s income. On the flip side, it also exposes you to the potential risk of losing part of your money when the fund’s portfolio declines. You do not become an owner of the fund’s underlying individual securities. Therefore, you do not have any voting rights that owning common stock in a company would entitle you to.

A fund’s performance is measured as the change in the fund’s total value, which is the sum of the value of all the fund’s underlying securities.

An infographic that shows how a mutual fund works. Investors buy shares in the fund company. The fund manager buys and manages the underlying securities for the diversified portfolio, generating the highest possible returns with the lowest risk. The returns will be passed on to the investors.

There are thousands of different mutual funds, and each one has its mission or investment goal stated in the fund’s prospectus. Some focus on growth stocks such as growth funds, while others might target companies with a valuation over $2 billion. They can be divided by investment objective, fund type, industry, and market capitalization. There is a mutual fund for almost any type of investment you can think of!

Mutual funds are structured as open-end funds. This means that the fund can issue an unlimited number of shares as opposed to a closed-end fund that has a fixed number of shares offered through an IPO (Initial Public Offering). Mutual funds are heavily regulated and have to comply with strict rules monitored by the Securities and Exchange Commission (SEC).

How Do Mutual Funds Function?

A mutual fund investor is a part-owner of the fund company. Professional fund managers manage mutual funds, and the fund’s performance and costs are largely dependent on how the fund is managed. 

Some funds are passively managed. These funds’ objective is to track an index and mirror its performance, not outperform it.  A passive fund manager doesn’t actively select the securities to buy and sell. Instead, they merely match the securities of the index they are tracking. Hence, passive funds tend to have a lower expense ratio than actively managed funds and require minimal steering and intervention.  Primary examples of passively managed funds are Exchange Traded Fund (ETF) and Index Funds.

Actively managed funds, on the other hand, strive at outperforming the market or a benchmark index. Moreover, since in an actively managed fund the investment company will employ a professional financial advisor and a team of other professionals, such as analysts, the overhead costs of managing such a fund are high.

A sole objective drives both management styles: to increase the fund’s Net Asset Value (NAV), which is the total value of the securities in the portfolio. Mutual fund shares can typically be purchased or redeemed as needed at the fund’s current NAV per share (NAVPS). The NAVPS, unlike a stock price, doesn’t fluctuate during market hours but is settled at the end of each trading day. A fund’s NAVPS is derived by taking the total current value of the securities in the portfolio, subtracting the fund’s expenses, and dividing it by the total number of outstanding shares. Outstanding shares are those held by all shareholders, institutional investors, and company officers or insiders. 

Many mutual funds are part of a much larger investment management company such as Fidelity Investments and The Vanguard Group.

Types of Mutual Funds

Mutual funds can be categorized into various types based on the investment security they represent. They can be categorized by investment objective, fund type, industry, and market capitalization. There is a fund available for every investor. Here are some of the most common types:

Equity Funds

Equity or stock funds typically invest in corporate stock. These funds can be subcategorized by size into small-cap, medium-cap, and large-cap funds. However, they can also be divided based on investment approaches, including aggressive growth funds (which hold stocks that usually do not pay dividends), income funds (which hold stocks that usually pay large dividends), and money value funds. Investment managers for an equity portfolio can blend its strategy between company size and investment style as long as they follows the fund’s investment objective.

Fixed-Income Funds

Another popular category is the fixed-income fund, often called a bond fund. This type of fund includes municipal bonds, investment-grade corporate bonds, and high-yield corporate bonds. These funds aim to have money flowing into the fund regularly through the fixed interest that the fund earns. The fund then passes on the return to the shareholders. The higher the risk level of the fund’s underlying securities, the higher the potential return of the fund is. For example, a fund that contains mostly high-yield corporate bonds will have a higher fixed interest rate and a higher return than a fund that contains municipal bonds.  

Index Funds

Another type of mutual fund that has gained traction in recent years is the index fund. This type of fund tracks a particular primary market index such as the S&P 500 or the Dow Jones Industrial Average. Index funds are passively managed funds, and they follow the belief that it is expensive and often troublesome to outsmart the market consistently. Index funds have lower management and analyst costs resulting in higher total returns for the investor.

Balanced Funds

Balanced funds, also known as asset allocation funds, hold a hybrid portfolio of different asset classes. The investments can range from stocks, bonds, money market instruments to alternative corporate overtures. The goal is to build a portfolio conducive to achieving high returns while only taking minimum risk. Most of these funds follow a formula to split the money among the different types of investments. They tend to take more risk than fixed-income funds but less risk than pure equity funds. Aggressive balanced funds hold more equities and fewer bonds, while more conservative balanced funds hold fewer equities than bonds.

Money Market Funds

Money market instruments are the safest, most risk-averse securities. These funds invest in short-term debt securities such as US Treasury bills and certificates of deposit. The goal is to maintain a stable asset value through liquid investments while paying dividend income to investors. Money market funds are a sanctuary for individuals who desire constant returns and nominal risk.

Exchange-Traded Funds (ETFs)

An ETF is a mix between a mutual fund and a stock. An ETF is a pooled investment vehicle that trades like a stock on a stock exchange but offers mutual fund diversification. ETFs entail features that a typical stock enjoys. It can be traded at any time during business hours, and its price fluctuates accordingly. It can also be sold short or purchased on margin. Most mutual funds do not trade on an exchange, their price does not fluctuate throughout the day as is it is set at the end of the day, and they cannot be sold short or bought on margin. ETFs have lower fees than most other types of mutual funds.

Mutual Fund Fees

Before selecting a particular mutual fund to invest in, it is imperative to understand the fee structure and the long-term impact of a fund’s fees and expenses. A small difference in fees can make a huge difference in your total future return. 

Investors pay two basic types of fees: expense ratios and sales commissions (sales loads).

Expense ratios

The expense ratio is the annual fee that a mutual fund charges its shareholders. It includes all the operating expenses of the fund, such as the management fees and administrative fees. According to the Investment Company Institute, the average expense ratio for a mutual fund is about 0.55%. However, some specialized funds can have expense ratios of over 2%. As the expense ratio is deducted from a fund’s earnings, it reduces the total return shareholders receive. The expense ratio for mutual funds has come down in recent years due to ETFs’ increased popularity. ETFs have lower overhead costs because they are passively managed. 

Sales loads

Sales loads are transaction fees paid when shares are purchased (front-end loads) and redeemed (back-end loads). They are paid directly by the investor to financial professionals, such as brokers or investment advisors. 

Sometimes investment companies will offer no-load mutual funds. These funds do not charge any sales commissions as the fund itself distributes the shares. Besides expense ratios and sales loads, some funds charge fees and penalties for withdrawal before the elapsing of a specified term. 

All these expenses and fees can add up, so an investor needs to understand how the different costs affect the fund’s performance and total return.

How to Buy Mutual Funds?

If you contribute to a 401K, a traditional individual retirement account (IRA), or a Roth IRA, there is a big chance that you already own a mutual fund, as the overwhelming majority of money in retirement plans goes into mutual funds. You can select one or more mutual funds and other investments for your retirement accounts.

A 401(k) plan is a company-sponsored retirement account that employees can contribute to. There are 2 types of 401(k)s, the traditional IRA with pre-tax contributions and the Roth IRA with after-tax contributions. 401Ks only offer a limited number of mutual funds that you can select from. You decide how much you want to contribute every month, and the amount will get automatically deducted from your paycheck.  Investing through a 401K at work is an effortless way to invest in mutual funds. Often companies match part of your contribution, which essentially is “free money” and a great benefit.

Buying mutual funds works a little differently from buying stocks. Mutual fund shares are purchased directly from the fund. You can invest in mutual funds by buying a certain number of shares or investing a certain amount of money. For example, you can buy 100 shares of the fund or decide to invest $10,000 because it is possible to buy a fraction of a share.

The price per share is determined by the Net Asset Value (NAV) at the end of the trading day. 

Advantages of Mutual Funds

Mutual funds are among the most popular investment vehicles in the USA to grow wealth and save for retirement. Why are mutual funds so popular? Here are some of the benefits of mutual funds:

  • Diversification – Diversification of a portfolio is THE key to successful investing as it reduces the risk. Mutual funds can offer a diversified portfolio at a relatively low cost, without having to purchase and monitor dozens or even hundreds of individual assets yourself. A truly diversified portfolio contains different securities with varying maturities, from different industries and different size companies. 
  • Easy to buy and sell – Once you select the mutual fund, your work is done. The fund manager distributes the shares and will actively buy and sell the fund’s underlying securities to generate the highest returns possible.
  • Professional Management – Fund managers are professionals who monitor and manage the fund daily according to the fund’s investment objective. 
  • Affordable and low minimum investment – Many funds have a low minimum investment amount. Some funds waive them all together for investors who buy shares within a 401K or sign up for an automatic investment plan. 

Disdvantages of Mutual Funds

  • High fees and commissions – Mutual funds charge an annual expense ratio, including management and administrative fees and transaction fees.
  • Lack of control – Investors have no say in which underlying securities the fund manager decides to buy or sell once they have invested in the fund. Fund managers are in control as long as they follow the fund’s investment objective stated in the fund’s prospectus.
  • Taxes – When a fund manager sells a security, the capital-gains tax has to be paid. These taxes can add up if the fund manager often buys and sells securities in the fund. However, by Investing in tax-sensitive funds or mutual funds through a tax-deferred account, such as an IRA or a 401K, taxes are avoided.
  • No FDIC coverage – The Federal Deposit Insurance Corporation (FDIC) does not insure mutual funds because they do not qualify as financial deposits.  

How To Make Money When Investing in Mutual Funds?

The easiest way for an investor to compare one fund’s performance over another is to compare each fund’s Total Return. The Total Return is the change in value (up or down) of the mutual fund over a specific time period. Therefore, the Total Return includes the following:

  • Dividends – When mutual funds receive a dividend or interest payment, they pass these on to the investor. Investors can often choose to receive these distributions as a cash distribution or reinvest them in the fund.
  • Capital Gains – When the fund sells securities that have increased in price, it triggers capital gain tax. When the fund sells securities that have gone down in price, this is a capital loss. Most funds will pass on net capital gains to its investors.
  • Net Asset Value – If the price of some of the underlying securities in the fund increases, and those securities do not get sold, the mutual fund’s share price increases as well. This increases the Net Asset Value of the fund. 

Are Mutual Funds a Sound Investment?

Many investors do not have the desire, the time, the expertise, and the experience that investing in individual securities requires. Mutual funds can be the perfect solution to this problem. It offers an investor a diversified portfolio managed by a professional fund manager who will generate the highest possible return while reducing risk and following the fund’s investment objective.

Before selecting a fund, investors need to consider some factors. The most important one is to ensure that the fund’s investment objective matches the investor’s investment goals and risk level. For example, if the investor is relatively close to retirement age, his desired risk level is probably pretty low, so a fund focusing on aggressive growth will not be a good choice, but a bond fund might be.

Another thing to consider is the past performance of the fund. Performance can be measured by looking at the Total Return of a fund. An investor should not only look at the fund itself but compare its performance to similar funds. Besides, a look into the future of the fund might help the decision-making process as well.

Finally, the fees and expenses of the mutual fund have to be taken into consideration. Actively managed funds are more expensive, but the higher returns might be worth it!

There is definitely a reason why mutual funds are so popular. They offer investors a relatively safe way to make investments that generate good returns at a relatively low-cost, and with minimum effort. However, mutual funds are not risk-free, and as with any other investment, you can lose money.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.