A Mutual fund is one of the most common tools investors use to build a portfolio. If you have a brokerage account to invest your cash — there’s a high likelihood your portfolio includes mutual funds. This article explains what a mutual fund is and how to start investing in the most popular types of mutual funds.
Table of contents
- What is a mutual fund?
- What are the benefits of mutual funds?
- Types of mutual funds
- How to Invest in Mutual Funds
- Index Funds vs. Mutual Funds
- Top 5 Biggest Mutual Funds
- Compete Risk Free with $100,000 in Virtual Cash
What is a mutual fund?
A mutual fund is a financial vehicle made up of a pool of money collected from multiple investors — often thousands — to invest in stocks, bonds, and other assets. Investors buy shares in the fund, which charges a fee for managing the investments inside it.
Mutual funds owe their popularity to the cost-effective way they give investors access to a broad range of assets that help balance risk and over time scoop up market gains. The average investor doesn’t have the expertise or cash to build a portfolio one stock or bond at a time. That’s why most lean on mutual funds to do the buying and selling for them.
A mutual fund is managed actively or passively, and which strategy a fund follows will influence its costs and expectations for the fund’s performance. An actively managed mutual fund is run by professionals who often try to beat the market. Passively managed funds follow a predetermined strategy and hope to mimic the performance of the market.
Actively managed accounts have higher fees — called expense ratios — than passive funds. They also carry higher potential rewards as well as risks: Studies show passive investing strategies often deliver better returns.
In the last years, mutual funds started to be replaced with Exchange Traded Funds (ETFs) as chosen investment funds.
What are the benefits of mutual funds?
Mutual funds can make cash in three ways: when a fund receives dividends or interest on the securities in its portfolio and distributes a proportional amount to its investors; when a fund sells a security that has gone up in price; and when the net asset value of a fund — and thus, your shares — increases.
Mutual funds create an economy of scale. Buying stocks and bonds would break the bank of the average citizen. Mutual funds pool the cash of thousands of investors, giving them a cost-effective way to benefit from gains in the market.
A mutual fund is a potent tool for diversifying retirement savings. By pooling resources, mutual funds also spread risk and give people greater choice among conservative and riskier investments, as well as a broader mix of industries and asset classes.
Types of mutual funds
There are about 8,000 mutual funds on offer with varying levels of risk and potential return. Here are some of the basics, starting with the least risky:
- Money market funds invest in high-quality, short-term debt issued by the U.S. government or corporations. Your return might not be much better than what you’d get with a savings account at a bank.
- Income funds also invest primarily in government and high-quality corporate debt, but their main objective is to provide a steady flow of income to investors. Retirees and conservative investors might be interested in these.
- Bond funds invest in, well, bonds and their risk level depends on the creditworthiness of the bond issuers. Government equals good; shady company equals less good.
- Hybrid or balanced funds invest in a blend of stocks, bonds, currencies, cryptocurrencies, and other securities, aiming to provide a solid mix of profit and security. Many hybrid funds are “funds of funds,” meaning they invest in other mutual funds. A common example is target-date funds, the default choice of many employer-sponsored retirement plans like 401(k)s.
- Equity funds invest in individual company stocks and carry the greatest risk, as well as the greatest potential returns. Market fluctuations can drastically affect your gains or losses.
Equity mutual funds can be sliced and diced in several ways depending on the goals of the fund:
Funds based on company size
Some funds focus only on “large-cap” or “small-cap” companies, which refers to the market capitalization, or value, of the companies:
- Large-cap fund: Companies with a market value of $10 billion or greater.
- Mid-cap fund: Companies worth $2 billion to $10 billion.
- Small-cap fund: Companies worth $300 million to $2 billion.
Industry or sector funds
These mutual funds focus on a particular industry, such as technology, oil, and gas, aviation, or health care. For example, investors who want exposure to gains by companies like Google and Apple could put money in a technology fund. Ownership in different sector funds can help diversify your portfolio, so if one industry is hit hard (like the bursting of the dot-com stock bubble in 2000), those losses can be offset by gains in other sectors.
Growth and value funds
The investment style of the fund is another mutual fund differentiator. Growth funds, as the name suggests, seek stocks that fund managers believe will have better than average returns. Value funds look for companies whose stock is (you guessed it) undervalued by the market.
International, global and emerging market funds
Geographic location can also determine how mutual funds are built. International funds invest in companies doing business outside the U.S., while global funds invest in companies doing business both in the U.S. and abroad. Emerging market funds target countries with small but growing markets.
How to Invest in Mutual Funds
The benefit is clear: A mutual fund pools the money from thousands of investors and, on their behalf, invests it across a wide range of asset types, industries, geographies and more — it’s diversification at a fraction of the cost.
Here are the 5 steps to buy mutual funds:
Step 1. Decide whether to go active or passive
Your first choice is perhaps the biggest: Do you want to beat the market or try to mimic it? It’s also a fairly easy choice: One approach costs more than the other, often without delivering better results.
An actively managed fund is managed by professionals who research what’s out there and buy with an eye toward beating the market. While some fund managers might achieve this in the short term, it has proved difficult to outperform the market over the long term and on a regular basis. This type of mutual fund is more expensive because of the human touch involved.
A more hands-off approach called passive investing is rising in popularity, thanks in large part to the ease of the process and the results it delivers. Passive investing is best for most people because the funds are cheaper and there are fewer fees.
Perhaps the signature passive investment is the index fund, which buys a basket of securities meant to represent an entire market. For example, the holdings in a Standard & Poor’s 500 fund mirror those in the popular index of 500 stocks, and the fund’s performance is meant to replicate the performance of the index itself. So when the evening news says the S&P 500 was up 3% for the day, so would your index fund. And since there’s no real management going on, its fees are lower than for an actively managed fund.
Step 2. Calculate your budget
When considering how much to invest, remember that patience pays. A good rule of thumb is you should feel comfortable leaving the money untouched for at least five years to ride out any market downturns.
Thinking about your budget in two ways can help determine how to proceed:
- How much do I need to get started? Mutual fund providers often require a minimum amount to open an account and begin investing. Some brokers have no account minimum; others can range from $500 to $3,000.
- How should I invest that money? As mentioned earlier, the great advantage of mutual funds is the low-cost way they offer to build a diverse portfolio across stocks (for growth) and bonds (for lower but steadier returns). But what initial mix of funds is right for you? Generally speaking, the closer you are to retirement age, the more holdings in conservative investments you will want to have — younger investors have more time to ride out riskier bets and inevitable reversals. One kind of mutual fund takes the guesswork out of the “what’s my mix” question: target-date funds, which automatically reallocate your asset mix as you age.
Step 3. Decide where to buy mutual funds
You need a brokerage account when investing in stocks, but you have a few options with mutual funds. If you contribute to an employer-sponsored retirement account, such as a 401(k), there’s a good chance you’re already invested in mutual funds. You also can buy directly from the company that created the fund. But each of these options may have a limited choice of funds.
Most investors would be wise to buy from an online brokerage, many of which offer a broad selection of mutual funds across a range of fund companies. If you go with a stockbroker, you’ll want to consider:
- Affordability. Mutual fund investors can face two kinds of fees: from their brokerage account (transaction fees) and from the funds themselves (expense ratios and front- and back-end “sales loads”). More on these below.
- Fund choices. Workplace retirement plans may carry only a dozen or so mutual funds. You want more variety than that. Some brokers offer hundreds, even thousands, of no-transaction-fee funds to choose from. There are many other types of funds available, such as exchange-traded funds, or ETFs, which offer the diversification benefits of mutual funds but can be traded like individual stocks; and target-date funds, which invest in other mutual funds and reallocate their assets to become more conservative over time.
- Research and educational tools. With more choice comes the need for more thinking and research. It’s vital to pick a broker like Admiral Markets (our top-ranked overall) that helps you learn more about a fund before investing your money.
- Ease of use. A brokerage’s website or app won’t be helpful if you can’t make heads or tails of it. You want to understand and feel comfortable with the experience.
Step 4. Understand and scrutinize fees
Back to the active-versus-passive question: Generally speaking, the service level of actively managed accounts will be higher, but so will the fees you pay.
Either way, a company will charge an annual fee for fund management and other costs of running the fund, expressed as a percentage of the cash you invest, known as the expense ratio. For example, a fund with a 1% expense ratio will cost you $10 for every $1,000 you invest. These fees aren’t always easy to identify upfront, but it’s well worth the effort to understand because they can eat into your returns over time.
Commissions aren’t a thing with mutual funds, but there still can be transaction fees for buying or selling a fund. Some funds also carry a charge that’s paid to the broker selling the fund, which sounds like a commission but is called a sales load.
The good news is you can sidestep these fees by investing with a broker that offers a list of no-transaction-fee mutual funds.
Step 5. Build and manage your portfolio
Once you determine the mutual funds you want to buy, you’ll want to think about how to manage your investment.
One smart move would be to rebalance your portfolio once a year, with the goal of keeping it in line with your diversification plan. For example, if one slice of your investments had great gains and now constitutes a bigger share of the pie, you might consider selling off some of the gains and investing in another slice to regain balance.
Sticking to your plan also will keep you from chasing performance. This is a risk for fund investors (and stock pickers) who want to get in on a fund after reading how well it did last year. But “past performance is no guarantee of future performance” — and it’s an investing cliché for a reason. It doesn’t mean you should just stay put in a fund — go on, shop the funds offered by your broker to see if you can find something similar for less — but chasing performance almost never works out.
Index Funds vs. Mutual Funds
Three main things distinguish an index fund from an actively managed mutual fund: who — or what — decides which investments the fund holds, the fund’s investment objective, and how much investors pay in fees to own it.
But perhaps the biggest difference between these two distinct categories of mutual funds is this: If given the choice, investors have a better shot at achieving higher returns with an index fund. Exploring the differences reveals why.
Passive vs. active management
Managing a mutual fund requires making daily (sometimes hourly) investment decisions. One of the differences between the index and regular mutual funds is who’s behind the curtain calling the shots.
There’s no need for active human oversight to determine which investments to buy and sell within an index mutual fund, whose holdings are automated to track a stock index — such as the Standard & Poor’s 500 — so if a stock is in the index, it will be in the fund, too.
Because no one is actively managing the portfolio — performance is simply based on price movements of the individual stocks in the index and not someone trading in and out of stocks — index investing is considered a passive investing strategy.
In an actively managed mutual fund, a fund manager or management team makes all the investment decisions. They are free to shop for investments for the fund across multiple indexes and within various investment types — as long as what they pick adheres to the fund’s stated charter. They choose which stocks and how many shares to purchase or punt from the portfolio. And here’s where the trouble starts for actively managed mutual funds.
If you can’t beat ‘em, join ‘em. That’s essentially what index investors are doing.
An index fund’s sole investment objective is to mirror the performance of the underlying benchmark index. When the S&P 500 zigs or zags, so does an S&P 500 index mutual fund.
The investment objective of an actively managed mutual fund is to outperform market averages — to earn higher returns by having experts strategically pick investments they believe will boost overall performance.
Potential outperformance of the index is the reason an investor would choose an actively managed fund over an index fund. But you pay a higher price for the manager’s expertise, which leads us to the next — and most critical — the difference between index funds and actively managed mutual funds.
The biggest difference to investors: Cost
As you can imagine, it costs more to have people running the show. There are investment manager salaries, bonuses, employee benefits, office space and the cost of marketing materials to attract more investors to the mutual fund.
Who pays those costs? You, the shareholder. They’re bundled into a fee that’s called the mutual fund expense ratio.
Investors pay more to own shares of actively managed mutual funds, hoping they perform better than index funds. But the higher fees investors pay cut directly into the returns they receive from the fund, leading the majority of actively managed mutual funds to underperform.
Index funds cost money to run, too — but a lot less when you take those full-time Wall Street salaries out of the equation. That’s why index funds — and their bite-sized counterparts, exchange-traded funds (ETFs) — have become known and celebrated for their low investment costs compared with actively managed funds.
But the sting of fees doesn’t end with the expense ratio. Because it’s deducted directly from an investor’s annual returns, that leaves less money in the account to compound and grow over time. It’s a fee double-whammy and the price can run high.
The bottom line: The lower the management costs, the higher the investment returns for shareholders.
Top 5 Biggest Mutual Funds
Currently, two companies dominate the domestic mutual fund market: Vanguard and Fidelity. Both offer very robust funds with high growth potential and have trillions under their belt in total assets. If you’re looking to cash in on the potential advantages of size in your mutual fund investments, here are the five largest mutual funds last year.
1. Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX)
- Assets under management: $921.4 billion
- Expense ratio: 0.04%
- 1-year performance: 19.14%
- 3-year annualized performance: 13.21%
2. Fidelity 500 Index Fund (FXAIX)
- Assets under management: $274.1 billion
- Expense ratio: 0.015%
- 1-year performance: 17.44%
- 3-year annualized performance: 13.16%
3. Vanguard Institutional Index Mutual Fund (VINIX)
- Assets under management:$231.6 billion
- Expense ratio: 0.035 percent
- 1-year performance: 17.44%
- 3-year annualized performance: 13.14%
4. Fidelity Government Cash Reserves (FDRXX)
- Assets under management:$210.4 billion
- Expense ratio: 0.38%
- 1-year performance: 0.39%
- 3-year annualized performance: 1.25%
5. Vanguard Federal Money Market Fund (VMFXX)
- Assets under management:$203.9 billion
- Expense ratio: 0.11%
- 1-year performance: 0.58%
- 3-year annualized performance: 1.49%
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When it comes to mutual funds, you can make money in three possible ways: Income earned from dividends on stocks and interest on bonds. A mutual fund pays out nearly all of the net income it receives over the year (in the form of a distribution). An increase in the price of securities (called a ‘capital gain‘).
With mutual funds, you may lose some or all of the money you invest because the securities held by a fund can go down in value. Dividends or interest payments may also change as market conditions change.
There are several major alternatives to investing in mutual funds, including exchange-traded funds (ETFs). ETFs usually have lower expense ratios than mutual funds, sometimes as low as 0.02%. ETFs do not have load fees, but investors must be careful of the bid-ask spread. ETFs also give investors easier access to leverage than mutual funds. Leveraged ETFs are far more likely to outperform an index than a mutual fund manager, but they also increase risk.