Earlier this year, the mutual fund industry celebrated its 100th birthday as the Massachusetts Investment Trust reached a century of operation. Since 1924, investors have been able to pool capital into funds that buy large swaths of stocks or other assets, providing unique types of diversification through a single security.
Mutual funds make up a large chunk of America’s investments and retirement savings, but they function differently than the assets traditionally traded on exchanges. A mutual fund company must calculate the price of its funds at the end of each trading session by dividing the total value of its holdings by the number of shares outstanding. Unlike stocks or exchange-traded funds (ETFs), mutual fund orders won’t be filled during the open session — only after the final bell sounds.
Before investing in mutual funds, you must ensure they suit your investment goals and long-term plan. Since they can’t be traded on exchanges, mutual funds are long-term assets, not short-term trading vehicles. In this article, we’ll explain how mutual funds fit into an investment plan and the different types available for your portfolio.
Decide on Your Goals
Why are you investing in the first place? Is it for a long-term goal like retirement or a more time-sensitive endeavor like a house down payment or a child’s education? Your goals and timeline will dictate which mutual funds you’ll choose for your portfolio.
Mutual funds don’t invest in the same pool of stocks — some are narrowed to specific sectors, company sizes, asset classes, or countries. Mutual funds investing in higher-risk companies will have a higher risk factor. For example, a mutual fund that tracks the tech sector will have more volatility than one that invests in bonds or a broad index like the S&P 500.
Before constructing your portfolio, set your goals in writing and have an investment plan you can revisit. If your goals change, you can always adjust your plan, but having a set roadmap will help with asset selection and prevent emotional decision-making.
Know the Lingo
If you aren’t familiar with mutual fund investing, you might not understand some of the terminology advisors or analysts use. Here are a few investment terms from the mutual fund world that investors should know.
- Net Asset Value (NAV): When a mutual fund performs its daily calculations, it looks for net asset value or the total value of all the fund’s holdings (minus liabilities) divided by the outstanding number of shares. NAV is calculated at the end of the trading session.
- Expense Ratio: The expense ratio is the amount the fund charges investors to cover its expenses and overhead costs, expressed as a percentage of assets. For example, if you have $10,000 invested in a fund with a 0.05% expense ratio, you’ll pay $5 annually in fees.
- Prospectus: The prospectus is a detailed document that mutual funds are required by law to produce. It contains information about the fund’s goals and objectives, risk factors, fees and expenses, management profiles, and past performance data.
- Active vs. Passive: Mutual funds come in many different varieties, but they tend to fall into one of two camps: active or passive. Active funds employ a fund manager who selects securities based on their personal analysis. Passive funds track an index like the S&P 500 or Nasdaq 100. Actively managed funds try to beat benchmark indices, while passive funds simply try to match the index's performance.
- Capital Gains Distributions: When the fund sells securities for a profit, it returns these profits to shareholders through capital gains distributions. The tax status of these distributions depends on the fund’s holding period, not the amount of time the investor has owned shares. However, the distribution is considered taxable income for the shareholder, so mutual fund owners must plan for taxes if they hold shares in a taxable account.
Choose the Right Type of Mutual Fund
Once you familiarize yourself with the terminology and build an investment plan, you must choose the mutual funds that suit your goals. Here are seven types of mutual funds you’ll encounter when researching assets.
1. Equity Funds
Equity funds invest in stocks, but the composition depends on the individual fund's objectives and goals. For example, value funds hold low P/E stocks, while growth funds hold stocks with solid revenue and earnings growth. Equity funds are designed for long-term investment, so they’re the primary choice for 401(k) account holders.
2. Bond Funds
If equity funds are pools of stocks, bond funds are naturally pools of different fixed-income securities like Treasuries and corporate bonds. While the risk factors vary, bond funds tend to be less volatile and produce more income through dividends. Bond funds are ideal for investors focused on consistent income and long-term growth.
3. Balanced Funds
Balanced funds combine stocks and bonds into a single asset, giving investors diversification across asset classes through a single security. Balanced funds mix long-term growth and short-term income production. Additionally, balanced funds can adjust their allocation over time to match investor preferences. Target-date funds are prime examples of balanced funds as they reduce stock allocation over time as the chosen retirement year approaches.
4. Money Market Funds
Money market funds are designed for capital preservation by investing in short-term debt securities like T-bills, commercial paper and certificates of deposit (CDs). These assets differ from bond funds, which may hold long-term debt, such as Treasuries or long-duration corporate bonds. Money market funds are safer than stock or bond funds but don’t provide much growth.
5. Index Funds
Mutual funds that track a particular index are known as index funds. Index funds are passive, meaning no fund manager picks stocks, which helps keep expenses down. Index funds are often the cheapest in the industry, and many outperform long-term stock pickers.
6. Sector and Industry Funds
Mutual funds can narrow their exposure to specific sectors or industries, such as consumer discretionary, tech, or the financial sector. Sector-specific funds are usually actively managed and often carry heavier expenses than broader funds.
7. Specialty Funds
Specialty funds invest in a particular investment theme or focus, such as international small caps or U.S. artificial intelligence stocks. Specialty funds are usually the most expensive mutual funds to own.
Evaluate the Mutual Funds
Once you’ve selected mutual funds for your portfolio, you must evaluate them before risking any capital. Here are some areas to review when picking funds:
Performance History
Past performance is not indicative of future results, but it's never a bad idea to see how a particular fund performed during different periods. For example, how did the fund do during bear markets or periods of rising inflation? Look at the fund’s track record in different environments before investing.
Mutual Fund Manager’s Track Record
If you're buying actively managed funds, you need a fund manager with a solid history. Make sure you know how long the manager has been at the fund and if the fund’s performance has changed under their watch. Just note that even the best managers, like Peter Lynch, eventually close shop when they feel their edge is gone.
Fees and Expense Ratio
Market returns and volatility are out of our control, but the price we pay for investments is not. It's okay to pay a high expense rate for a narrow or specialty fund; just be sure to compare the expenses of similar funds before investing. A few basis points can add up to a significant loss of investment profit when timeframes are measured in decades.
Turnover Ratio
How often does the fund buy and sell securities? High-turnover funds create capital gains distributions, which can create tax headaches for unprepared investors. Before buying any shares, always have an idea of how often the fund turns over its holdings.
Where can mutual funds be purchased? Here are some common options:
Brokerage Accounts
Most mutual funds can be purchased directly from your brokerage app. Just type in the mutual fund ticker and enter your order. For more information, check out our guide on selecting a brokerage account for your investments.
Financial Advisor
If you employ a financial advisor, you can purchase shares through them. Contact your advisor to review your options if you want to change your investment plan and buy mutual fund shares.
Mutual Fund Companies
You can buy shares directly from the mutual fund companies themselves. If you’re interested in a particular family of funds, visit the company website and look for information about directly purchasing shares.
Retirement Plans
Since mutual funds are the main investments in 401(k) accounts, many employees can purchase them through their employer’s retirement plan. To find out which mutual funds are available, you'll need to contact your employer or plan administrator.
Monitor Your Portfolio
Even though mutual funds are not as liquid as stocks and ETFs, you still need to monitor your investments, especially since your goals can change over time.
If you own a target-date fund in a retirement account, you won’t need to do much portfolio rebalancing. But if you self-direct your mutual fund investments, you’ll need to monitor financial and economic conditions to ensure your goals are still on track to be met. Periodic rebalancing can help minimize volatility and create efficient tax situations.
Diversification Through a Single Asset
Mutual funds have provided investors with easy diversification for a century, and the industry has never been more affordable and diverse. Broad market index funds often carry expense rates of just a few basis points, and there are thousands of funds for investors to choose from. However, mutual funds have a unique structure that investors must understand to prevent tax surprises. Be sure to consult with an advisor before making significant adjustments to your portfolio.
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