Chances are, when you go to the supermarket, you don’t fill your cart up with just one item. Instead, you buy vegetables, pasta, cheese, fresh bread, maybe a nice bottle of wine — all the various ingredients you need to create a delicious meal.
It’s similar to investing in mutual funds. You put your money into lots of different things that work together to help you pursue your investment goals. But you’re not making dinner, you’re developing a recipe for building wealth. So, what are mutual funds and how do they work?
What are mutual funds?
A mutual fund pools money from numerous investors and invests it into different securities. Think of it as a basket holding different types of investment assets. When you buy shares of a mutual fund, you purchase everything inside the basket.
A mutual fund can invest in:
- Individual stocks
- Real estate
- Precious metals
- Commodities, such as oil or wheat
Mutual funds can even hold other mutual funds. (This is called a fund of funds.)
How do mutual funds work?
It can be time consuming and costly to trade hundreds or even thousands of securities on your own, but mutual funds allow you to diversify your holdings (which is one way to manage risk) and benefit from professional management. When you buy shares of a mutual fund through a brokerage like Ally Invest, you become a shareholder in that fund, owning a portion of each of the securities included in the fund.
A fund manager decides what securities to buy and sell inside the fund, based on the fund’s investment objective. They also oversee the fund’s trading activities and use their own expertise and knowledge to guide their decision-making.
So how do you make money with mutual funds? You can earn returns two different ways.
The first: dividends. A dividend represents a share of a company’s profits. If a mutual fund holds individual stocks that pay dividends, it can collect these payments and distribute them to its investors. A mutual fund’s prospectus will tell you if it pays dividends. (A prospectus is a document that essentially breaks down how the fund invests, its past performance and what you’ll pay to own it.)
The other way to make money investing in mutual funds is through capital gains. A capital gain occurs when a fund manager sells a security held inside the fund for more than its initial purchase price. You can also realize a capital gain by selling your shares of a mutual fund for more than what you paid.
How do capital gains affect your taxes? Read about the tax implications of trading.
Types of Mutual Funds
Mutual funds make portfolio diversification easier, since you can pick and choose which mutual funds to buy based on your risk tolerance and financial goals.
You can categorize mutual funds two different ways:
- How they invest
- What they invest in
Let’s start with how mutual funds determine their investment strategy. First, you have actively managed funds. With these, the fund manager has one goal: to beat the market, delivering above-average returns to fund investors.
Passively managed funds, on the other hand, have a different investment objective. Their goal is to “meet” the market by matching the performance of a specific benchmark.
Mutual funds can be further broken down by what they invest in. Each type can offer a different risk/reward profile, depending on what it invests in. Broadly speaking, you can choose between:
The most popular type of mutual fund, equity (or stock) funds invest mainly in stocks. They can be actively or passively managed and carry a higher level of risk than some other types of mutual funds.
Passively managed index funds try to mimic the performance of a market index, like the Nasdaq 100 or the S&P 500, and are usually comprised of most or all of the stocks that make up the index.
Usually referred to as bond mutual funds, they invest in a variety of government or corporate bonds (that’s debt issued by businesses). Fixed-income funds are typically less risky than other types of investments and most provide interest income via dividends.
Money Market Funds
Investing in low-risk, short-term debt like U.S. Treasurys and cash, these funds can be good if you’re looking to add an investment to your portfolio that is typically resistant to market volatility.
This type of mutual fund invests in a mix of stocks and bonds.
Income funds are made up of fixed-income securities like bonds that pay interest income via dividends. Because of this, they are generally considered less risky than mutual funds that aim to earn capital gains.
International funds only hold securities of companies outside of the U.S. These funds offer a way to diversify your portfolio, but they can carry greater risk.
Target Date Funds
A popular way to invest for retirement, these mutual funds are designed with their asset allocation aligned with your preferred retirement date. Hint: They’re easy to recognize since they typically have a year (i.e. 2045, 2050, etc.) in their fund name.
Growth funds tend to focus on companies that have the potential for above-average growth.
These funds invest in companies that have been undervalued by the market.
Mutual Funds vs. Other Investments
As you learn more about mutual funds, you’ll likely find that, on the surface, some of their features look similar to other types of investments. But dig a little deeper, and you’ll begin to see what makes mutual funds unique.
Mutual Funds vs. ETFs
Mutual funds and exchange-traded funds or ETFs sound similar — they’re both basket-like investments that allow you to diversify your portfolio by investing in hundreds or thousands of securities. Plus, they both can pay dividends. The main difference in a nutshell: An exchange-traded fund trades throughout the day on an exchange just like a stock.
Normally, when you buy or sell one or more mutual fund shares, the trade is only executed once per day — after the market closes — at the fund’s daily net asset value (NAV). With an ETF, trades can be executed throughout the trading day or even during after-hours trading if you’re using an online brokerage that allows it. That means you don’t have to wait for NAV to be calculated. Instead, you can take advantage of whatever price an ETF is trading for at that particular moment.
Mutual Funds vs. Index Funds
The main difference between a mutual fund and index fund is that index funds invest only in securities found on a specific index. For example, an index fund may invest in all the stocks found on the S&P 500. Mutual funds may invest in a variety of stocks, regardless of what index they are benchmarked against. As we mentioned, index funds are passively managed and only seek to match their benchmark’s performance, not beat it. Because of this, an investor might lean toward index funds over actively managed mutual funds if they want lower fees with potentially more stable returns.
Mutual Funds vs. Stocks
When you buy shares of a stock, you invest in a single company. In contrast, when you purchase shares of a mutual fund, you’re investing in hundreds or thousands of companies at one time. If you recall, that’s because a mutual fund can be thought of as a basket holding a variety of securities.
Mutual Fund Expenses and Fees
Mutual funds can charge ongoing fees and transaction fees. All of these charges will be listed in the fund’s prospectus.
Ongoing fees are the different charges included in the fund’s expense ratio (aka the annual cost of owning the fund):
- Management fees paid to the fund manager or the investment firm that oversees the fund
- 12b-1 fees, which go toward the marketing and selling of the fund
- Operational fees, including accounting, recordkeeping and legal fees
The expense ratio is expressed as a percentage of fund assets. For example, a mutual fund might have an expense ratio of 0.50% or 0.75%. Different mutual funds can have different expense ratios, depending on whether they’re actively or passively managed and what they invest in. Some may be significantly more expensive than others.
As a general rule, index funds and other passively managed mutual funds tend to have less expensive expense ratios than actively managed funds, but it’s always important to compare them side by side to see how the costs add up.
Transaction fees include expenses like trading fees, fund share redemption fees and sales charges (aka loads). When it comes to these fees, mutual funds can be categorized by having a …
- Front-end load: Commission or sales charges you pay at the time of purchasing the mutual fund shares.
- Back-end load: Fee you pay when selling mutual fund shares. This can either be a flat fee or one that gradually decreases the longer you hold the shares.
- No-load: No fee is charged, typically as long as you’ve held the fund for a certain amount of time.
How to Start Investing in Mutual Funds
The simplest way to start investing in mutual funds is to open an online investment account, which you can do with Ally Invest. Then, decide which funds you’d like to add to your portfolio by considering …
- Which asset class or classes the fund represents (i.e. stocks, bonds, etc.)
- Whether it’s actively or passively managed
- Fund performance and the fund manager’s track record
- Recurring and one-time fees
Finally, think about how a fund matches up with your goals, risk tolerance and time horizon to see how it’ll fit into your portfolio’s asset allocation. Now, you’re ready to go forth and discover how mutual funds can be part of a recipe for building wealth.
Trade mutual funds commission-free.