Investors looking to save for the long term often use mutual funds. By investing in a mutual fund, investors can hold a variety of assets within one investment.
What are mutual funds?
Mutual funds refer to companies that combine money from various investors to buy stocks, bonds, and other assets. As a result, they can offer a more diversified portfolio that goes beyond an individual investor’s capacity.
Apart from the above, different types of mutual funds are available, including index funds, bond funds, and target-date funds.
Investors in mutual funds do not possess direct ownership of the fund’s investments, meaning they don’t own any individual stocks or bonds. Instead, they equally share the profits and losses from the fund’s overall holdings. This is why they are called “mutual” funds.
Common types of mutual funds
Mutual funds broadly fall into four different asset classes:
- Equity funds
- Bond funds
- Balanced funds
- Money market funds
Equity funds
According to the Investment Company Institute, the majority of mutual funds (55%) are equity funds. These stock funds can potentially offer higher returns, but they also come with more downside risk than other types of funds.
Equity mutual funds are segmented by the fund’s goals.
Market capitalization
Some equity mutual funds focus on the size of the companies they invest in.
Mutual fund types by market capitalization
- Large-caps only invest in companies valued at $10B and above, while
- Mid-caps target companies worth between $2B and $10B, and
- Small-caps aim for those in the $300M to $2B range.
Investment style
Mutual funds can also be distinguished by their style.
- Growth funds aim to invest in stocks that a professional fund manager predicts will yield above-average returns.
- Value funds search for companies that appear to be undervalued by the market.
- Income funds aim to provide investors with a stream of income derived from interest or dividend payments.
Industry-specific
Sector funds invest in specific industries like technology, healthcare, or aviation, to name a few. So, if an investor is looking to benefit from companies in the pharmaceutical or health insurance sectors, they can invest in a healthcare fund.
Owning shares in various sector funds can help diversify your investment portfolio and help avoid the risk of being overinvested in just one industry.
Geographic location
Mutual funds can also base their investments on where they are in the world. Here are three types:
- International funds invest in non-US companies.
- Emerging market funds invest in small countries that show signs of potential growth.
- Global funds focus on companies conducting businesses in and out of the US.
Bond funds
Bond funds are also commonly referred to as fixed-income mutual funds because of the periodic interest payments (coupons) investors receive quarterly, semiannual, or annually.
A bond fund’s risk exposure depends on its underlying investments, which range from conservative government bonds to riskier corporate debt.
Overall, funds in this category are considered safer than equity mutual funds but have less upside potential.
Balanced funds
As the name suggests, these funds aim to maintain a specific risk and reward ratio by mixing equity and bond funds (e.g., 70% stocks/30% bonds).
You might also hear these investments referred to as “asset-allocation” or “target-date” funds.
Money market funds
Money market mutual funds are fixed-income investments that invest in short-term debt from banks, governments, or companies.
This very low-risk investment typically holds assets like US Treasuries, certificates of deposit (CDs), and commercial paper (short-term, unsecured promissory notes issued by corporations).
Why do investors invest in mutual funds?
Investing in a single mutual fund exposes an investor to hundreds of stocks, bonds, or other investments.
This method is particularly popular among people who prefer a more hands-off approach to investing but still want to benefit from the stock market’s returns.
What are the differences between active and passive mutual funds?
A mutual fund’s fees and performance will depend on whether it is actively or passively managed.
Passively managed funds aim to replicate the performance of a specific benchmark, like the S&P 500, rather than trying to outperform it. As a result, they generally do not need a team of portfolio managers to actively manage them. This leads to lower expenses for the fund, and thus, passive mutual funds often have lower fees than actively managed ones.
Actively managed mutual funds have a team of professionals making investment decisions. These professionals aim to surpass the market or a benchmark index; however, research indicates that passive investing strategies generally yield greater returns.
Unlike exchange-traded funds (ETFs) that are mostly passively managed, most mutual funds are actively-managed funds.
Mutual fund fees and expenses
Operating a mutual fund involves several costs, including expenses related to investor transactions like purchases, exchanges, and redemptions.
Additionally, regular costs associated with fund operations, like advisory fees, marketing and distribution expenses, brokerage fees, custodial fees, transfer agency fees, legal fees, and accountant fees, also exist.
Certain funds charge fees and expenses to investors when they make transactions or for their accounts. These fees are listed in the fee table at the start of the fund’s prospectus under “Shareholder Fees.”
Usually, funds use their assets to pay for their regular operating expenses instead of charging investors separately. However, it’s important to note that even though these expenses are paid using fund assets, investors still indirectly pay for them.
These expenses are listed under “Annual Fund Operating Expenses” in the fund’s prospectus fee table.
Shareholder fees
Sales loads
Sales loads are commissions paid to a broker when you purchase or redeem (sell) shares in a mutual fund. These fees are usually represented as a percentage of the investment amount, such as 5%, and can be charged by both front-end (when you buy) and back-end load funds (when you sell).
- Front-end loads: The upfront commission you pay when you purchase a mutual fund. The percentage comes out before you invest, reducing the number of shares you can buy.
- Example: If you invest $10,000 to purchase mutual fund shares that charge a front-end load of 5%, $500 will come out of your account, leaving you with $9,500 to invest.
- Back-end loads: You pay this commission when you sell your shares back to the fund. Also referred to as redemption fees or deferred sales charges, all of your money is invested upfront (assuming no other fees were charged at purchase). Only when you redeem your shares will you have to pay a fee.
- Example: If you invest $10,000 in a fund that has a 5% back-end load, your full amount will be invested in the fund. However, when you sell your shares, you will be charged 5%—typically on your initial investment—which would be $500.
Most investment companies use a back-end sales load called a contingent deferred sales charge (CDSC). This sliding fee scale decreases the back-end charges every year you own the fund until it eventually goes to zero.
(Carefully read the fund’s prospectus to see how your fees are calculated)
Annual operating expenses
Management fees
Management fees are deducted from a fund’s assets and paid to the fund’s investment adviser or its affiliates. These fees cover managing the fund’s investment portfolio and administrative expenses not categorized as “Other Expenses.”
12b-1 fees
The fund pays these fees from its assets to cover distribution and occasionally shareholder service costs.
The term “distribution fees” refers to the costs associated with promoting and selling shares of a fund. This can include compensating brokers who sell shares, covering the cost of advertising, printing and mailing prospectuses to new investors, and printing and mailing sales materials.
Expense ratio
Expense ratios reflect the total cost of owning a mutual fund. A fund’s expense ratio is a percentage of its average net asset value that pays for all of the previously mentioned fees.
What is a “good” expense ratio?
For an actively managed fund where the fund’s portfolio is regularly traded, a fair expense ratio is between 0.5% and 0.75%. Anything over 1.5% is high.
Are mutual funds more expensive than ETFs?
The short answer is yes—ETFs are typically cheaper than most mutual funds. The reason is how they are managed: most ETFs are index funds, meaning they are passively managed. In contrast, most mutual funds are actively managed funds.
Final word
There’s no such thing as a perfect investment. Each comes with its own risks and fees, so understanding where you are putting your money is vital to ensure you meet your objectives.
But it can be tough doing it alone.
Want to learn what you are really paying for your investments? Let’s chat. We’re happy to do the heavy lifting.
