What Are Mutual Funds?
By David S. Chang
A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds. Each share represents an investor’s part ownership in the fund and the income it generates.
Mutual funds are the most common 401(k) and retirement account investments. They appeal to a wide range of investors for several reasons: They’re diversified, they’re professionally managed and they’re liquid, which means you can sell shares when you wish although you may have a loss if the fund has dropped in value.
Why do people buy mutual funds?
Mutual funds are a popular choice among investors because they generally offer the following features:
- Professional Management. The fund managers do the research for you. They select the securities and monitor the performance.
- Diversification or “Don’t put all your eggs in one basket.” Mutual funds typically invest in a range of companies and industries. This helps to lower your risk if one company fails.
- Affordability. Most mutual funds set a relatively low dollar amount for initial investment and subsequent purchases.
- Liquidity. Mutual fund investors can easily redeem their shares at any time, for the current net asset value (NAV) plus any redemption fees.
What types of mutual funds are there?
Most mutual funds fall into one of four main categories – money market funds, bond funds, stock funds, and target date funds. Each type has different features, risks, and rewards.
Money market funds have relatively low risks. By law, they can invest only in certain high-quality, short-term investments issued by U.S. corporations, and federal, state and local governments.
Stock funds invest in corporate stocks. Not all stock funds are the same. Some examples are:Target date funds hold a mix of stocks, bonds, and other investments. Over time, the mix gradually shifts according to the fund’s strategy. Target date funds, sometimes known as lifecycle funds, are designed for individuals with particular retirement dates in mind.
- Growth funds focus on stocks that may not pay a regular dividend but have potential for above-average financial gains.
- Income funds invest in stocks that pay regular dividends.
- Index funds track a particular market index such as the Standard & Poor’s 500 Index.
- Sector funds specialize in a particular industry segment.
Types of Stock Funds
- Stock funds, sometimes known as equity funds, invest in a variety of ways. If you have a choice, it’s generally better to choose two or three funds buying different types of stock than to concentrate on funds investing in the same way.
- One key difference is between growth funds and value funds. In brief, growth fund managers look for stocks whose prices they expect to go up as the companies’ products or services reach wider markets and their earnings increase. Value fund managers look for stocks that are seen as undervalued, or low-priced, because the company or sector is currently out of favor with investors. Value funds often outperform growth funds when the economy isn’t strong. But there’s still a risk with value funds because not all companies recover from setbacks or recapture investors’ interest.
- Another important distinction is size, or market capitalization. Large capitalization, or large-cap, companies tend to be more price stable and less vulnerable to major losses than small-cap companies. That’s true in part because they have larger financial reserves. On the other hand, small- and mid-cap companies may have more growth potential.
- You may find that the funds in your plan combine these designations, so you may have a choice between a small-cap growth fund and small-cap value fund, or between a large-cap growth fund and mid-cap value fund.
- Your plan may also offer more narrowly focused sector funds, which invest in one segment of the economy, such as healthcare or utilities, or a contrarian fund, which invests in stocks other investors are shunning. Some plans also offer international stock funds, which invest in companies based in other countries.
- Many 401(k) plans offer index funds as part of their investment menu, and these funds tend to be popular choices. An index fund is designed to mirror the performance of a specific market index, such as the S&P 500 Index. If you believe that there’s no way for a mutual fund manager to consistently beat the market over the long term, you may prefer index funds to trying to select among managed funds.
- In addition, index fund fees tend to be lower, sometimes significantly lower, than managed fund fees, because buy and sell decisions are based exclusively on changes in the composition of the relevant index so there’s no need for research or day-to-day investment decisions.
- Of course, in a down market, an index fund will drop in value along with the index it mimics while some managed funds may achieve a stronger performance. That’s one risk of using these funds. Another risk is that many indexes—and therefore the funds that track them—are not as diversified as they seem. Because an index is typically weighted, a limited number of securities may determine the direction of the index. For example, the S&P 500 index emphasizes the performance of stocks with the highest market values.
Bond funds have higher risks than money market funds because they typically aim to produce higher returns. Because there are many different types of bonds, the risks and rewards of bond funds can vary dramatically. Bond funds provide interest income from the underlying investments in the fund’s portfolio. While you’re investing in your 401(k), that income is reinvested to buy additional shares. Allocating a portion of your 401(k) contribution to these fixed income investments can play an important role in creating a diversified portfolio, reducing investment risk and helping you achieve your long-term goals.
You can differentiate bond funds from each other in two ways: by the types of bonds a fund owns and by the average term of the bonds in the fund.
There are generally five categories of bond funds:
- US Treasury bond funds, which invest in bills, notes or bonds issued by the federal government
- Agency bond funds, which invest in bonds backed by a pool of mortgages and issued by either agencies of the federal government or government-sponsored enterprises
- Municipal bond funds, which invest in tax-exempt bonds issued by cities and states in order to fund public projects
- US corporate bond funds, which invest in bonds issued by US companies
- International bond funds, which invest in bonds issued by corporations based overseas or by governments other than the US
The average maturities of the bonds in a fund may be grouped as:
- Short term, with an average maturity of one year or less
- Intermediate term, with an average maturity of 2 to 10 years
- Long term, with an average maturity of 10 years or longer
The longer a bond fund’s average maturity, the more sensitive it is to changes in interest rates. As rates go up, the net asset value (NAV) of the fund drops. And as rates drop, the NAV increases. From an investment perspective, what matters most is a bond fund’s total return. That’s the interest the underlying bonds pay, which is reinvested to buy more shares, plus any increase or decrease in the value of your principal. The greater the total return, the better your investment is doing.
A long-term bond fund has greater potential than a short-term bond fund to generate high total returns when rates are falling, but its total return is more likely to decline when rates are rising. The most volatile bond funds, called high-yield funds, invest in low-rated bonds with the greatest risk of default.
Balanced funds are the most truly diversified mutual funds because they invest in stocks, preferred stocks and bonds in order to provide both potential growth and current income. By holding both asset classes, balanced funds tend to be less volatile than either pure stock or pure bond funds.
The major drawback of a balanced fund may be that it tends to under-perform pure stock funds in a bull market because only a portion of the fund’s assets is invested in stock. The average stock allocation, which is typically about 60 percent of the total portfolio, is spelled out in the fund’s prospectus, along with any limits the fund manager must follow.
For example, a manager may have the right to shift investments in changing economic environments but be required to keep a minimum of 25 percent in stocks or bonds at any given time. Changes in the current interest rate may also affect a balanced fund’s performance, especially if the fund is invested in long-term bonds in a period when interest rates are rising. That will tend to reduce the fund’s total return.
Stable value funds and guaranteed investment contracts (GICs) are designed to preserve capital. That means they make investments that have a low risk of losing money.
Stable value funds guarantee the value of your principal, which is your initial investment, and promise a fixed rate of return. They may buy US Treasury and corporate bonds as well as interest-bearing contracts from banks and insurance companies. Or all of the fund’s assets may go into GICs. GICs are insurance company products that resemble individual bonds or CDs—the issuer has use of your money for the term of the contract, and pays a fixed rate of interest in return. While it is highly unlikely a stable value fund will lose money, such as scenario has occurred.
Pros and Cons of Capital Preservation
Stable value funds and GICs typically pay interest at a higher rate than money market mutual funds. That’s one reason some investors who want to diversify a 401(k) account that contains more volatile investments, such as stock mutual funds, may choose these funds.
However, the interest rate on a stable value fund or GIC is generally guaranteed for only a predetermined time, sometimes as brief as three months, and varies with changing market conditions. Further, if you want to shift money out of the account, you may have to pay a penalty—sometimes a substantial one. That’s not the case when you move money from a stock or bond fund into another investment.
One downside of capital preservation alternatives is that they’re less likely to provide long-term protection against inflation. That can be a problem. You don’t want to find yourself short of the income you need in retirement.
What are the benefits and risks of mutual funds?
Mutual funds offer professional investment management and potential diversification. They also offer three ways to earn money:
- Dividend Payments. A fund may earn income from dividends on stock or interest on bonds. The fund then pays the shareholders nearly all the income, less expenses.
- Capital Gains Distributions. The price of the securities in a fund may increase. When a fund sells a security that has increased in price, the fund has a capital gain. At the end of the year, the fund distributes these capital gains, minus any capital losses, to investors.
- Increased NAV. If the market value of a fund’s portfolio increases, after deducting expenses, then the value of the fund and its shares increases. The higher NAV reflects the higher value of your investment.
All funds carry some level of risk. 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.
A fund’s past performance is not as important as you might think because past performance does not predict future returns. But past performance can tell you how volatile or stable a fund has been over a period of time. The more volatile the fund, the higher the investment risk.
How to buy and sell mutual funds
Investors buy mutual fund shares from the fund itself or through a broker for the fund, rather than from other investors. The price that investors pay for the mutual fund is the fund’s per share net asset value plus any fees charged at the time of purchase, such as sales loads.
Mutual fund shares are “redeemable,” meaning investors can sell the shares back to the fund at any time. The fund usually must send you the payment within seven days.
Before buying shares in a mutual fund, read the prospectus carefully. The prospectus contains information about the mutual fund’s investment objectives, risks, performance, and expenses.
As with any business, running a mutual fund involves costs. Funds pass along these costs to investors by charging fees and expenses. Fees and expenses vary from fund to fund. A fund with high costs must perform better than a low-cost fund to generate the same returns for you.
Even small differences in fees can mean large differences in returns over time. For example, if you invested $10,000 in a fund with a 10% annual return, and annual operating expenses of 1.5%, after 20 years you would have roughly $49,725. If you invested in a fund with the same performance and expenses of 0.5%, after 20 years you would end up with $60,858.
It takes only minutes to use a mutual fund cost calculator to compute how the costs of different mutual funds add up over time and eat into your returns. See the Mutual Fund Glossary for types of fees.
By law, each mutual fund is required to file a prospectus and regular shareholder reports with the SEC. Before you invest, be sure to read the prospectus and the required shareholder reports. Additionally, the investment portfolios of mutual funds are managed by separate entities know as “investment advisers” that are registered with the SEC. Always check that the investment adviser is registered before investing.
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