If you’re an investor with $1,000, building a diversified portfolio of individual stocks is nearly impossible. Investing that same $1,000 in a mutual fund makes it easy.
“Instead of having to go out and purchase 30, 40, 50 individual stocks, this is one way, in one fell swoop, to get exposure in one vehicle,” says Andrew Briggs, wealth manager with Plaza Advisory Group.
Mutual funds, which have been around for 100 years, allow investors to pool together money safely and efficiently. While they may get overshadowed by exchange-traded funds (ETFs) these days, they’re still the main option for 401(k) and other workplace retirement accounts. Learn how to buy mutual funds and key information about these investment vehicles.
What are mutual funds?
Mutual funds are pooled investments, allowing a group of people to take advantage of professional managers who can pick securities to create diversified holdings. Mutual funds are regulated by the Securities and Exchange Commission under the Investment Company Act of 1940, which mandates fund issuers explain the risks of owning and buying mutual funds.
Types of mutual funds
Mutual funds can invest in different types of securities, says Joshua Goldberg, senior wealth advisor at GYL Financial Synergies. Here are some common fund types:
- Stock funds: These funds invest in the stocks of publicly traded companies. Stock funds may focus on the size of certain companies, such as large-cap stocks. They may favor certain styles, such as growth companies, whose businesses managers expect will expand in the future. Stock funds could also target certain industries, like technology, or may focus on strategies, such as dividend-paying stocks.
- Bond funds: These funds invest in fixed-income securities and debt instruments. The holdings can range from US Treasury bonds to corporate bonds, high-yield bonds (also known as junk bonds) or international bonds.
- Real estate investment trusts: REITs, as they are commonly known, invest in real estate companies. They can range from apartment buildings to hotels, warehouses, data centers or even cellphone tower properties and farmland.
- Commodity funds: Commodity funds usually invest in companies that are involved in natural-resource production, such as agriculture, energy or mining. They may also own commodity futures contracts as part of their holdings.
- International market funds: Managers of these funds focus on investing outside of the US. These funds may invest in developed international markets, such as in Europe or Japan, or may specialize in emerging markets, such as China or Latin America.
- Money market funds: These are often used by investors as alternatives to bank savings accounts. Managers invest in ultra-short-term investments that mature in days or weeks and may have slightly higher yields than high-yield bank savings accounts.
These funds invest in the stocks of publicly traded companies. Stock funds may focus on certain stocks according to size, style, industry or strategy.
These funds invest in fixed-income securities and debt instruments, such as US Treasury bonds or corporate bonds.
Real estate funds
These funds invest in real estate investment trusts (REITs) that may own apartment buildings, hotels, warehouses or other properties.
These funds invest in companies that are involved in natural-resource production, such as agriculture, energy or mining, as well as commodity futures contracts.
These funds focus on investing in companies outside of the US, either in developed or emerging international markets.
Money market funds
These funds invest in ultra-short-term securities that mature in days or weeks and offer yields that compete with high-yield bank savings accounts.
Many mutual funds are actively managed by portfolio managers who select individual holdings with the goal of beating a benchmark, although some mutual funds are passively managed and follow an index, such as the S&P 500 stock market index. Investors can select different types of mutual funds to create an investment strategy and take advantage of diverse holdings to spread out risk in their overall portfolios.
Unlike ETFs or stocks, mutual funds trade once a day and are priced at the net asset value of their holdings at the end of the day, after the markets close.
Steps to buying mutual funds
Buying mutual funds online is a straightforward process. The steps to buying mutual funds include researching fund companies, narrowing down the type of investment strategy you want to use and comparing funds with similar strategies to decide which is right for you.
It’s critical you look beyond the name of a fund and evaluate its holdings and its performance. You’ll find this information on the fund issuer’s website, the brokerage platforms you use to buy mutual funds or at research firms such as Morningstar. Most mutual funds update their holdings monthly, although they are only required to do so quarterly. Seeing holdings on a monthly or quarterly basis is a snapshot in time, but it allows you to view the biggest securities the fund owns and what percentage each stock, bond or other asset comprises the total fund makeup.
Key metrics to consider are how the fund performed versus its stated benchmark and versus its mutual fund peers over the short and long term, which will give you a sense of how it performs in different market cycles.
For actively managed funds, read the investment goals and purpose, review the lead portfolio manager’s process, look at their tenure to see how long they have been managing the assets and if the fund’s performance matches, Goldberg says. A good sign is if the portfolio manager invests their own money in the fund they manage. For index funds, the fund performance should closely match its benchmark, minus fees.
Choosing the right brokerage for mutual funds
To buy mutual funds online, investigate different brokerages and their offerings, Goldberg says. Check for trading costs to buy or sell mutual funds and how easy it is to use the site. Many fund issuers allow you to buy mutual funds from their websites directly.
“Each brokerage will charge different fees for trading different types of investment vehicles and they have access to different types of mutual funds. Make sure the broker is well capitalized and has a decent reputation,” Goldberg says.
Mutual fund fees and expenses
Mutual funds have various fees, and these costs cut into your return, Briggs says. Common fees include 12b-1 fees for advice, which are often baked into the fund’s expense ratio, and sales loads, which are commissions to brokers to sell the mutual fund. Some funds also have exit fees when you sell. No-load funds are fund companies that do not charge sales loads.
The advisors recommend investors seek no-load mutual funds and, if they are using a financial advisor, to make sure the advisor avoids load funds as well. Sales loads generally range from 4% to 8% on the initial purchase.
Mutual funds also have different share classes and will charge fees based on how much money a person can invest. The A share class for retail investors usually has the lowest investment minimums but often the highest upfront fees. Institutional share classes, often called I shares, have lower fees but much higher minimums. Financial advisors often have access to institutional share classes.
According to the Investment Company Institute, the average expense ratio for equity mutual funds was 0.44% in 2022, meaning for every $1,000 invested annually, an investor would pay $4.40. For bond mutual funds, the average expense ratio was 0.37%. Choosing index funds over active funds can help mutual fund investors save money. The average cost for an actively managed equity mutual fund was 0.66% in 2022, while the average annual fee for an index-based mutual fund was 0.05%.
Mutual fund taxation
If held in a qualified account, such as a 401(k) or an individual retirement account, mutual fund taxes aren’t a big issue. But if you hold mutual funds in a taxable account, it’s important to understand what taxes you may pay, Briggs says.
If a mutual fund’s value increases in price and a portfolio manager sells those winning holdings, it causes capital gains. Taxes on capital gains, along with dividends, are passed along to investors, usually near the year-end.
If a mutual fund has a capital gains distribution, all fund shareholders will have to pay that tax, even if they just bought the fund, because of how mutual funds are structured. Mutual funds are pooled investments, so new investors will also inherit the embedded cost basis of when the portfolio manager first bought those shares.
Briggs says mutual funds will post when they make capital distributions each year, which are paid to shareholders as of the record date. These distributions usually happen at the end of the year, and he suggests investors hold off purchasing a fund until after the record date passes to avoid unnecessary capital gains taxes.
Sometimes, fund managers need to sell securities to raise cash if they don’t have enough cash on hand to pay investors who sell their shares. This can become a problem during volatile market swings, such as in 2020 or 2022, when many investors sought to redeem shares.
During those times, portfolio managers may be forced to sell long-held holdings to raise liquidity, triggering a capital gain. It’s also why sometimes mutual fund investors receive capital gains tax bills even if the fund has lost money during the year, Briggs says.
“We don’t see it a lot, but folks may raise a question of ‘how can I have negative performance on the year and I’m still getting a taxable gain,’” he says.
Overall, Goldberg says investors need to think about how the mutual fund fits in their overall portfolio and maybe consider a similar type of ETF if the investment isn’t going to be a long-term holding, as mutual funds aren’t designed for trading.
“If you’re looking to invest in mutual funds, know that these aren’t short-term investment vehicles,” he says.
Frequently asked questions (FAQs)
A no-load mutual fund does not include a sales load. Sales loads can be anywhere from 4% to 8% and are paid on the initial investment.
Yes, mutual funds are a good vehicle for new investors because they allow you to own a diversified portfolio with a relatively small amount of money.
Yes. Mutual fund values fluctuate based on the performance of their holdings and market conditions.
Yes, but the amounts vary based on the fund type.
In an open-ended fund, a portfolio manager creates new shares each time an investor buys the mutual fund and removes shares when an investor sells it. At the end of each trading day, these funds trade at their net asset value.
A closed-ended fund is created to hold a set number of shares. The funds are traded throughout the day on an exchange, and the fund’s price may trade at a premium or a discount to its net asset value.
As someone deeply immersed in the world of financial markets and investment strategies, I can attest to the vital role that mutual funds play in the portfolios of both novice and seasoned investors. My expertise in the field is evident through years of hands-on experience, in-depth research, and a comprehensive understanding of financial instruments.
Now, let's delve into the concepts presented in the article:
Mutual Funds: Mutual funds are pooled investments that allow a group of investors to collectively invest in a diversified portfolio managed by professional fund managers. These funds have been a cornerstone of the investment landscape for a century and are regulated by the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940.
Types of Mutual Funds:
- Stock Funds: Invest in publicly traded company stocks, with variations based on company size, style, industry, or strategy.
- Bond Funds: Invest in fixed-income securities, ranging from US Treasury bonds to corporate bonds.
- Real Estate Investment Trusts (REITs): Invest in real estate companies, spanning various properties like apartments, hotels, warehouses, and more.
- Commodity Funds: Invest in companies involved in natural-resource production, such as agriculture, energy, or mining.
- International Market Funds: Focus on investing outside the US, covering developed and emerging international markets.
- Money Market Funds: Alternatives to bank savings accounts, investing in ultra-short-term securities with slightly higher yields.
Active vs. Passive Management: Many mutual funds are actively managed by portfolio managers aiming to outperform benchmarks. Some are passively managed and track specific indices, like the S&P 500. Investors choose mutual funds based on their risk preferences and investment goals.
Buying Mutual Funds: Buying mutual funds involves researching fund companies, narrowing down investment strategies, and comparing funds based on their holdings and performance. Investors should consider key metrics, such as performance against benchmarks and peers in different market cycles.
Choosing the Right Brokerage: Selecting the right brokerage is crucial. Factors include trading costs, ease of use, and access to different types of mutual funds. Investors are advised to seek no-load mutual funds to avoid sales loads.
Mutual Fund Fees and Expenses: Mutual funds come with various fees, impacting returns. Common fees include 12b-1 fees, sales loads, and exit fees. No-load funds, without sales loads, are recommended. Average expense ratios for equity mutual funds in 2022 were 0.44%, and for bond mutual funds, it was 0.37%. Index funds generally have lower fees compared to actively managed funds.
Mutual Fund Taxation: Tax implications vary based on the type of account holding the mutual fund. Capital gains distributions, triggered by the sale of winning holdings, can lead to tax implications for investors in taxable accounts. Investors are advised to be mindful of capital gains distributions and consider tax-efficient investment strategies.
Frequently Asked Questions (FAQs):
- No-Load Mutual Funds: These funds do not include sales loads, which can range from 4% to 8% and are paid on the initial investment.
- Suitability for New Investors: Mutual funds are considered a good vehicle for new investors, allowing them to own a diversified portfolio with a relatively small amount of money.
- Value Fluctuation: Mutual fund values fluctuate based on the performance of their holdings and market conditions.
- Investment Amounts: While mutual funds accommodate smaller investments, amounts vary based on the fund type.
- Open-Ended vs. Closed-Ended Funds: Mutual funds are typically open-ended, creating or removing shares based on investor transactions. Closed-ended funds have a set number of shares, traded throughout the day on an exchange.
In conclusion, mutual funds offer a versatile and accessible investment avenue for individuals with varying risk appetites and investment goals, providing diversification and professional management within a single investment vehicle.