Building a portfolio can feel intimidating when you look at the sheer number of options available. You want your money to grow, but you also want to avoid the stress of picking individual winners and losers. That's exactly why mutual funds were created. They offer a way to team up with other investors and access a broader range of assets than you might be able to buy on your own.
What exactly is a mutual fund?
Think of a mutual fund as a company that brings together money from various investors to purchase a basket of stocks, bonds, and other assets. This structure allows the fund to offer a diversified portfolio that goes far beyond what an individual investor could typically build alone.
When you invest in a mutual fund, you don't possess direct ownership of the fund's investments. You don't own the Apple or Microsoft stock directly. Instead, you equally share the profits and losses from the fund's overall holdings. That's why they're called "mutual" funds.
The four main types of mutual funds
Most mutual funds fall into one of four distinct asset classes.
1. Equity funds
Equity funds are just another name for stock funds. According to the Investment Company Institute, the majority of mutual funds (55%) are equity funds. While these can potentially offer higher returns, they also come with more downside risk than other types of funds.
We can break these down further based on the size of the companies they buy or their investment style.
By market capitalization (company size):
- Large-caps: These funds only invest in companies valued at $10B and above.
- Mid-caps: These target companies worth between $2B and $10B.
- Small-caps: These aim for companies in the $300M to $2B range.
By investment style:
- Growth funds: These aim to invest in stocks that a professional manager predicts will yield above-average returns.
- Value funds: These search for companies that appear to be undervalued by the market.
- Income funds: These aim to provide investors with a stream of income derived from interest or dividend payments.
- Sector funds: These invest in specific industries like technology, healthcare, or aviation. Owning shares in various sector funds can help diversify your portfolio so you aren't overinvested in just one industry.
By geography:
- 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 business both in and out of the US.
2. Bond funds
These are commonly referred to as fixed-income mutual funds because of the periodic interest payments, or coupons, that investors receive. These payments might come quarterly, semiannually, or annually.
A bond fund's risk depends on what's inside it. Underlying investments can range from conservative government bonds to riskier corporate debt. Overall, funds in this category are considered safer than equity mutual funds but usually have less upside potential.
3. Balanced funds
As the name suggests, these funds aim to maintain a specific risk and reward ratio by mixing equity and bond funds. For example, a fund might hold a mix of 70% stocks and 30% bonds. You might also hear these investments referred to as "asset-allocation" or "target-date" funds.
4. Money market funds
Money market mutual funds are fixed-income investments that invest in short-term debt from banks, governments, or companies. This is a very low-risk investment type that typically holds assets like US Treasuries, certificates of deposit (CDs), and commercial paper. Commercial paper is simply a term for short-term, unsecured promissory notes issued by corporations.
Why do investors choose mutual funds?
The primary driver is diversification. Investing in a single mutual fund exposes you to hundreds of stocks, bonds, or other investments instantly.
This method is particularly popular among people who prefer a more hands-off approach to investing. It allows you to benefit from the stock market's returns without needing to analyze every single company yourself.
Active vs. passive management
When you look at a fund's fees and performance, it usually comes down to whether it's 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. Because they aren't paying a large team of portfolio managers to make constant decisions, they have lower expenses. This leads to lower fees for you.
Actively managed funds have a team of professionals making specific investment decisions to try and 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.
Understanding the fees and expenses
Operating a mutual fund involves several costs. Some are transaction-based, while others are ongoing operational costs. It's vital to look at the "Shareholder Fees" and "Annual Fund Operating Expenses" in the fund's prospectus.
Shareholder fees (sales loads)
Sales loads are essentially commissions paid to a broker when you buy or sell shares. These are usually a percentage of your investment.
- Front-end loads: This is a commission you pay when you buy. If you invest $10,000 in a fund with a 5% front-end load, $500 comes out immediately. That leaves you with only $9,500 actually working in the market.
- Back-end loads: This is a commission paid when you sell. If you invest $10,000 with a 5% back-end load, the full amount is invested upfront. However, when you sell, you get charged 5% (typically on your initial investment), which would be $500.
Most investment companies use a specific type of back-end load called a contingent deferred sales charge (CDSC). This is a sliding scale where the fee decreases every year you own the fund until it eventually goes to zero.
Annual operating expenses
Even if you don't see a transaction fee, you're paying for the fund's operation indirectly through fund assets.
- Management fees: These pay the investment adviser for managing the portfolio and administrative expenses.
- 12b-1 fees: These cover distribution and marketing costs. This includes compensating brokers, advertising, and printing prospectuses.
The expense ratio
The expense ratio is the most important number to watch. It reflects the total percentage of the fund's assets used to pay for all those management and operating fees.
So, what's a "good" expense ratio? For an actively managed fund where the portfolio is regularly traded, a fair expense ratio is between 0.5% and 0.75%. Anything over 1.5% is considered high.
Are mutual funds more expensive than ETFs?
The short answer is yes. ETFs are typically cheaper than most mutual funds. The reason goes back to management style. Most ETFs are index funds, meaning they're passively managed. In contrast, most mutual funds are actively managed, which requires more overhead.
The Facet difference
There's no such thing as a perfect investment. Each option comes with its own risks and fees, and understanding where you're putting your money is vital to ensuring you meet your objectives. But doing it alone can be tough, and the jargon can be overwhelming.
At Facet, we're believers in a transparent, flat-fee membership model. We don't sell products for commissions, and we don't hide behind confusing fee structures. You'll work with an expert team, including a CFP® professional, to help build a financial roadmap that reflects your life and values. If you want to know what you're really paying for your investments, let's chat.
