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If you’re interested in the investment space, but you’ve got little to no knowledge of the financial markets, then it might be best to invest in a mutual fund.
Basically, this means that you allow a fund manager to manage your money. In doing so, they will actively buy and sell assets on your behalf.
While there is never any guarantee that a mutual fund will make money, you’ll typically be entrusting your investment allocation with a highly experienced fund manager.
If you’re looking to find out what a mutual fund is in more detail, you’ve come to the right place. In our comprehensive guide, we’ve covered everything from how a mutual fund works, what they invest in, how you make money, and of course—how you can get started with an investment today.
What is a Mutual Fund?
Mutual funds are one of the common investment vehicles in the financial markets. The underlying concept is that by investing your money into a mutual fund, your investment portfolio will be taken care of. In fact, mutual funds will pool your money alongside the funds of other investors. This gives mutual funds significant purchasing power in the financial markets.
There are literally thousands of mutual funds available to choose from. While some focus on traditional blue-chip stocks and shares, others might concentrate on bonds. As we will discuss further down, each mutual fund will have its own risk category. For example, while some only invest in low-risk government securities, others might concentrate on the emerging markets.
Regardless of the investment strategy, each fund will typically have a fund manager. This will be a highly experienced investor that has an impeccable track record in the financial markets. Beneath the fund manager will be a highly comprehensive team, that will consist of traders, analysts, and order executors.
The main benefit of investing in a mutual fund as opposed to choosing investments yourself is that you get to utilize the knowledge of highly skilled investors. In return for managing your money, you will need to pay a fee. This can vary quite considerably, so we’ll also cover this in more detail later.
As a final note, it is also important to mention that mutual funds will usually strive to outperform the market. For example, if the fund primarily invests in US stocks, it will seek to outperform the S&P 500 index. Otherwise, mutual funds would not be able to justify their fees.
How Do Mutual Funds Work?
Once you invest your money into a mutual fund, you will not be required to do anything further. In fact, the only time that you need to make contact with the mutual fund is when it comes to withdrawing your money out.
In terms of assessing whether or not your fund is making a profit, this will be determined by the underlying net asset value (NAV). This is equivalent to the assets that the mutual fund has under management.
For example, if the mutual fund has $300 million worth of Apple stocks and $200 million worth of Nike stocks, then the NAV would be $500 million. Much in the same way as a conventional company stock, your ownership of that NAV will be determined by the amount you have invested. For example, if you had $1 million invested in the above mutual fund, then your proportion would be 5%.
Now, as the value of the underlying assets contained within the mutual fund’s portfolio of holdings will go up and down depending on market conditions, so will the NAV. For example, if the NAV at the time of your investment was $500 million, and then 10 years later it was worth $1 billion, then you would have made gains of 100%.
It is also important to note that you can make money from a mutual fund when the underlying equities pay out dividends. If and when stocks within a fund manager’s portfolio receive dividends, this will increase the NAV. As such, your overall proportion of that NAV will increase and your wealth will grow.
What Types of Mutual Funds are There?
Although mutual funds come in a variety of types and sizes, they generally sit within four main categories. We’ve expanded on these below.
Stock funds will focus exclusively on the stock markets. However, it is important to expand on this as there is a bunch of different stock funds to choose from.
Stock funds will typically focus on growth generating stocks (capital gains), income stocks (dividends), or a combination of the two. On the other hand, some mutual funds might target a specific sector. This could include a fund that specializes in technology, energy, or retail stocks.
As we briefly noted earlier, some stock funds might focus on the emerging markets. If they do, fund managers might look to purchase shares listed on stock markets in India, Turkey, Brazil or South Africa, for example.
Bond funds will focus exclusively on the bond markets. For those unaware, bonds operate in a multi-trillion dollar marketplace, so the choices are plentiful. Bond funds might target government bonds, corporate bonds, or a combination of the two.
Higher risk fund managers might even look to access the municipal bond market. Either way, this particular segment of the mutual fund space is focused on the fixed-income that bonds yield. As such, this makes them slightly less risky than stock funds.
Money Market Funds
Money market funds are less popular than they once were, mainly because the returns are relatively low. Characterized as a low-risk, low-return investment, money market funds offer high liquidity as they concentrate on super low-risk investments that are either issued by the US government or a trusted US-listed corporation.
And finally, a balanced fund will seek to diversify across all of the aforementioned asset classes. As such, the underlying portfolio will likely contain stocks and shares (both low and higher risk equities), bonds, and short-term government securities.
What Are the Benefits of Mutuals Funds?
The overarching benefit of using a mutual fund is that you get to tap into the portfolio of a highly experienced investor. Not only will the fund manager have extensive knowledge of the particular sector they are involved in (e.g. blue-chip stocks, government bonds, etc.), but they will also work towards certain strategic goals.
For example, if you invested in a fund that targets stocks listed on the London Stock Exchange, then the fund manager will strive to outperform the hallmark FTSE-100 index.
Although you will need to pay to invest in a mutual fund, the fees are a lot lower than you would think. For example, most mutual funds will come with an annual maintenance fee of less than 1%. When you factor in the highly advanced nature of what a fund manager brings to the table, you’re getting a very good value for the money.
In reality, mutual funds are one of the best forms of passive income. The reason for this is that you are not required to have any input in the investment decision-making process. As the fund manager will decide what assets to buy and sell and when, you can simply sit back and allow the passive income to take care of itself.
When you invest in a mutual fund, you are essentially diversifying your portfolio overnight. Irrespective of the specific market the fund is involved in, they will hold a vast range of assets. As such, this has the desired effect of mitigating your long-term risk. In fact, you can even diversify further by investing in multiple mutual funds!
Access to Institutional Markets
Another great benefit which is often understated is that mutual funds will have direct access to markets that you as a retail investor would not be able to access. This is because of the sheer size of assets the mutual fund will have under its belt. One such example of this is access to foreign government bond market. Typically, foreign governments will only allow investors to purchase bonds in minimum lot sizes that can often exceed $1 million or its equivalent in local currency.
An additional market that mutual funds can access is the IPO (Initial Public Offering) scene. For example, the recent listings of Uber, Pinterest, and Lyft were only available to institutional investors, thus you wouldn’t have been able to get in on the action until the shares were offloaded at a premium.
How to Make Money from Mutual Funds?
When it comes to making money from a mutual fund investment, this is typically achieved in three different ways. We’ve broken them down in more detail below.
First and foremost, if the mutual fund you put your money into invests in traditional blue-chip stocks, then you will benefit from any subsequent dividend payments that are distributed.
For example, let’s say that the mutual fund has British American Tobacco (BAT) stocks within its portfolio. When BAT pays its quarterly dividends, they will be paid directly to the mutual fund. However, as you effectively own a fraction of the portfolio held by the mutual fund—proportionate to the amount you invested, you have a right to your dividends share.
The key difference between a mutual fund and a traditional stock broker account is that the former will not forward the dividends on to you. Typically, when you hold stocks with an online broker, the dividends would be credited to your main cash balance. On the contrary, mutual funds will simply add the dividend payment to their overall net asset value (NAV). We’ll cover this in more detail below.
Net Asset Value
Although we briefly covered the concept of NAV earlier in our guide, it is important to expand further. Essentially, the NAV will dictate how much your investment is worth at any given time. Let’s take a look at another quick example so that you have a firm grasp of how the NAV works, with respect to investing in a mutual fund.
A mutual fund currently has $2 billion under management—all of which are in stocks and shares. As the total value of the stocks and shares on the day that you invest amounts to $2 billion, this is the NAV of the mutual fund.
However, as the NAV is entirely dependent on market conditions—of the stocks and shares it holds—it will rise and fall on almost a second-by-second basis. Let’s say that in three years time, the exact same portfolio of stocks and shares now has a value of $3 billion.
This means that in the three years you have held your investment with the mutual fund, the overall value of your investment has increased by 50%. As such, if you invested $20,000 initially, your investment would now be worth $30,000 ($20,000 x 50%).
This last point links directly to what we discussed in the previous section on dividends (and capital gains in the next section). Ultimately, the true value of your investment will be dependent on the NAV, which in theory, will increase when the mutual fund receives dividend payments.
The final metric that will allow you to make money from a mutual fund is via capital gains. This is when the value of the assets held by the mutual fund increases in value. This is not only relevant to just stocks and shares. On the contrary, it can be applied to virtually any asset class. For example, this could include commodities such as gold or silver increasing in value, or government treasury bonds selling at a premium—which increases the value.
Ultimately—and much like in the case of dividend payments, if the value of the assets being held by your respective mutual fund goes up, it will have a positive impact on the overall NAV. As discussed earlier, this will then result in the value of your investment going up.
Before we move onto the next section, it is important to note that the above examples make the assumption that your mutual fund investment will increase in value. As we all know, there is no guarantee that this will happen. While mutual funds are most commonly managed by highly experienced investors and the best performing funds consistently make gains, this isn’t always the case. In fact, very few mutual funds on Wall Street made a profit at the height of the financial crisis in 2009, so do bear this in mind.
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Disadvantages of Mutual Funds
Here’s a quick breakdown of some of the biggest drawbacks to investing in a mutual fund.
- Fees: When you invest on a DIY (do-it-yourself) basis via an online stock broker, you’ll typically pay very low fees. This is either in the form of a per-trade fee, or a percentage of your total trade size. There are even online brokers such as Robinhood or Webull that allow you to buy and sell blue-chip stocks for free. On the other hand, mutual funds will most often cost more—especially if the mutual fund in question is a top-performing fund. Although fees will rarely exceed 1% these days, you do need to be mindful of such costs.
- Zero Control: This particular disadvantage is also an advantage, depending on how you view it. Regarding the former, when you invest in a mutual fund, you have absolutely no say in the investment decision-making process. This means that if you were to identify a particular investment opportunity, you would either need to invest additional savings with a stock broker, or sell some of your mutual fund holdings to pay for it—which might come with a fee.
- Tax: When you use a traditional broker to make your own investments, you will need to pay tax on any gains that you make. This is implemented at the point that you sell the shares, and is calculated against the amount you originally paid. In this sense, you have both control and transparency over your tax obligations.
Although the process is similar with mutual funds, you need to remember that the fund will be taxed each and every time they exit a trade. If the fund in question utilizes a high turnover strategy—meaning they only hold assets on a short-term basis—then this will attract frequent tax liabilities, even though you haven’t sold your mutual fund investment.
How Much Do Mutual Funds Cost?
In terms of how much you should expect to pay when investing in a mutual fund can vary depending on the fund manager in question. However, in most cases this is based on an ‘Expense Ratio’.
The expense ratio is expressed as a percentage and will typically fall between 0.5% and 1%. However, fund managers with a long-standing track-record of consistently outperforming the market might charge more.
Regardless of what percentage you are liable to pay, this will be based on the amount you have invested in the fund. For example, if you invested $10,000 and the respective expense ratio was 0.5%, then you would pay $50 per year.
It is important to note that this fee is not taken from your balance per say. On the contrary, the fund manager will deduct this from the overall NAV of the fund. For example, if the mutual fund has a NAV of $2 billion and the expense ratio is 0.5%, then the fund manager will deduct $10 million from the fund each year.
This acts as a nice incentive for the fund manager to produce consistently good results. If the fee was based on a fixed amount, then the mutual fund might not be as motivated to outperform the market.
How Do I Invest in Mutual Funds?
If investing in a mutual fund is something you are interested in, then the good news is that the process is super straightforward. In most cases, you actually have two options.
The easiest and usually most cost-effective way of investing in your chosen mutual fund is to invest directly with the fund. This won’t always be an option for you as a retail client, as some fund managers will have a minimum investment threshold.
If this is the case, then you can invest in a mutual fund via an online stock broker. Ally Invest, Betterment, E*TRADE, TD Ameritrade, and Charles Schwab—plus hundreds more—all offer you the chance to invest in a mutual fund at the click of a button. Each platform will have its own pros and cons, so make sure you spend some time researching the broker in question.
Once you have made an investment, you don’t need to do anything else until you are ready to sell. While some mutual funds will have a minimum holding period, most don’t.
However, take note as you might need to pay a fee to withdraw your money out of your chosen mutual fund. As such, make sure you check this before parting with your money.
Popular Mutual Funds
As there are literally thousands of mutual funds operating in the market, we thought it might be best to quickly discuss some of the popular funds in 2020.
Invesco S&P SmallCap Health Care ETF (PSCH)
The Invesco S&P SmallCap Health Care ETF (PSCH) is a mutual fund focused on health care stocks. In fact, the mutual fund operates more like an ETF, insofar that the fund will attempt to replicate the performance of the index like-for-like. In 2018, the fund made annual gains of 29.55% with a rather juicy expense ratio of just 0.29%.
Vanguard 500 Index
If you’re looking to invest in the wider US economy, you can’t go wrong with the Vanguard 500 Index. The mutual fund will purchase stocks in the top 500 performing companies listed on the two main US stock exchanges—the NYSE and NASDAQ.
With a somewhat low minimum investment of $3,000, alongside a very competitive expense ratio of 0.16%, this is a hugely popular mutual fund to invest in.
Fidelity Select Consumer Staples
Market murmurs on an impending global recession appear to be getting stronger. The ongoing trade dispute between the US and China, the UK’s Brexit saga, and negative interest rates in the Eurozone are further amplifying market uncertainties. With that being said, you might want to consider the Fidelity Select Consumer Staples fund.
In a nutshell, this particular fund will invest in companies that sell goods and services that we all need in society—irrespective of market conditions. Think along the lines of food, transportation and healthcare. The fund comes with a minimum investment of just $2,000, although the expense ratio is slightly higher at 0.77%.
If you’ve read our comprehensive guide on mutual funds from start to finish, you should now have a firm understanding of how they work. We’ve covered everything from how mutual funds make money, the different types of assets that fund managers invest in, and why you should consider investing in one.
Although fund managers are an excellent investment vehicle for traders of all shapes and sizes, it is imperative to note that there is never any guarantee that you will make money. For example, when the global financial crisis reached its pinnacle in 2009, very few fund managers made money. This was especially true in the case of stock funds.
Your best option is to choose a number of different mutual funds that each operate in a different marketplace. This way, you can further mitigate your risks by diversifying even further.
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Ricardo is an entrepreneur, investor and personal finance nerd who enjoys spending time with his family and friends, travelling and helping others achieve their financial goals. Ricardo has been quoted as a personal finance expert in several online publications including Healthline, Bankrate, GOBankingRates, MSN Money, Yahoo Finance, U.S. News & World Report, Forbes and USA Today.