What is a mutual fund?

What are mutual funds, and how do they work?

Mutual funds are among the most popular types of investments today because of their accessibility. Most company-sponsored retirement plans offer a mix of mutual funds.

Nearly half of U.S. households own shares in at least one mutual fund.¹

Mutual funds are popular because they give individual investors a way to instantly diversify their investments, even if there is only a small amount to invest. Instead of purchasing stock in one or two companies, you can indirectly invest in hundreds. This reduces risk since the price fluctuations of any one stock will not have a serious effect on your overall investment. Of course, diversification does not assure a profit or protect against market loss.  

A mutual fund pools the money that individuals invest in that fund and creates a diversified portfolio in line with the fund’s goals. It can contain stocks, bonds, or other financial assets. A money manager (an individual or company) oversees how the fund is invested. The fund’s dividends, profits, and losses are shared by all of its investors proportionately.

Types of mutual funds

There are many categories and classes of mutual funds.  Differentiators include the sector (or sectors) in which the fund invests, its long-term objectives, its risk profile, and its potential for returns. While there is nearly infinite variety among mutual funds, here are a few important terms you should understand:

Value funds look for well-established companies with undervalued stocks. They often pay higher dividends, while still having room for appreciation when the market recognizes that a stock in the portfolio is undervalued.

Growth funds invest in companies that the money manager expects to grow rapidly and that offer the potential to realize a higher capital appreciation. Growth funds can sometimes be riskier than value funds.

Index funds follow entire indexes, like the Dow Jones Industrial Average or the S&P 500. They rely on the overall growth of the stock market over time instead of the performance of any individual stock or industry. They are traditionally more stable than other funds, and they are easier to manage, which leads to lower operating costs and fees.  

Bond funds offer slow, predictable, and sometimes guaranteed rates of return, which can make them a good base for conservative investors. Since there are many types of bonds, however, the risk profile of bond funds can vary wildly. Do your research before investing in one.

Income funds are most often attractive to people who are already in retirement, as their goal is to provide steady income. They achieve this by investing in bonds and holding them until maturity. They generally don’t appreciate much over time, so they are not great long-term savings vehicles.

Are mutual funds tax-free?

A few are, but most aren’t. Since mutual funds can include many different types of financial assets, the tax status of various mutual funds is a complicated topic. Some mutual funds that invest in government and municipal bonds may be able to grow tax-free, while some can be included within tax-deferred accounts, like IRAs. In addition, mutual funds may be subject to ordinary income taxes and/or capital gains taxes. Alternative minimum tax can also apply. In order to fully understand your options and how they might affect your taxes now and in the future, speak with your tax advisor.

Are mutual funds FDIC insured?

No. Mutual funds are not FDIC insured (as bank accounts are). In fact, mutual funds’ performance is not guaranteed at all. This means that there is always a chance of losing a portion of your money if the underlying stocks or bonds within the fund perform poorly.

Are mutual funds safer than individual stocks?

No investment is without risk, and some mutual funds are inherently riskier than others. However, they are generally considered less risky for small investors than individual stocks, given that you’re able to diversify your portfolio more easily with mutual funds. That means your portfolio is at less risk of big swings if one or two of your stocks perform poorly.

What’s the difference between a mutual fund and an ETF?

Exchange-traded funds (ETFs) are a relatively new type of investment. Like mutual funds, ETFs hold many different assets and help you diversify your portfolio. However, they trade more like stocks.

Related: What is an Exchange Traded-Fund (ETF)?

Are mutual funds good investments?

Mutual funds are incredibly popular for good reason, but like all investments, they come with risk. Not every mutual fund is equal, and many actively managed funds charge higher fees but do not outperform index funds. That said, the diversification aspect of mutual funds can give individual investors the peace of mind that comes from knowing that their investment is not vulnerable to the fluctuations of an individual stock.

Learn more about your investment options.

Advantages and drawbacks of mutual funds

With any investment, there are pros and cons. Two mutual funds can be very different, but here are a few general aspects to keep in mind as you build your personal investment strategy:

Mutual fund advantages:

• Diversifies your portfolio
• Low minimum investment
• Easily purchased on most investing platforms
• Professionally managed
• Large variety of choices

Mutual fund drawbacks:

• Fees and expenses
• Comparing funds can be difficult
• Can only trade at the end of the day

Starting a mutual fund investment

Purchasing shares in a mutual fund is an easy and straightforward process. With just about any online investment platform, you can buy and sell mutual funds from your computer or phone. Be aware that if you participate in a 401(k), you will be limited to the mutual funds offered in your company’s plan.

How do you start a mutual fund account?

Once you have an investment platform, or a brokerage account, you’ll want to research which mutual funds make the most sense for you. There are thousands of options that have different mixes of assets, investment strategies, and expense ratios. If you’re unsure which is right for you, go over your options. After that, you can simply invest whatever amount is appropriate for you. From start to finish, it could take you as little as 15 minutes. You may be required to answer a few questions about the specific mutual fund(s) you select, like whether you want dividends reinvested into the fund. Remember, mutual funds only trade at the end of the day, after the market has closed, so your request will likely show up as pending until after-hours.

How much do you need to invest in a mutual fund?

One thing to keep in mind when shopping for mutual funds is that many require a minimum investment, usually between $500 and $5,000. In addition, many offer volume discounts for higher investment amounts, called breakpoints, which may reduce or eliminate the amount of the front-end sales charge. Although breakpoints vary, many fund families offer sales charge discounts for investments at different numbers, often above $25,000.

Mutual fund fees

Most mutual funds have annual operating costs that are passed on to the shareholders. All these combined fees are often called an expense ratio. Usually this is around 0.05% to 1.5%. While this number seems small, over time these fees can have a dramatic effect on how fast your investment grows. For example, if a fund has an annual growth rate of 3%, but the expense ratio is 1%, a full third of its growth is negated by fees. For that reason, it’s good to shop around, not only to find funds that meet your goals, but to find funds that have lower expense ratios. In addition to these yearly fees, some mutual funds have commission fees when you buy or sell them, called a load.

Mutual fund returns

Your shares in a mutual fund typically grow and increase in value through dividends, capital gains, and an increase in the net asset value (NAV).

Any dividends that a stock within the mutual fund pays are passed on to the shareholders and can usually be received as cash or reinvested to purchase more shares of the fund.

Capital gains occur when an actively managed fund sells a security that has increased in price. Most mutual funds distribute these gains to investors annually, and this can influence your taxes.

Similar to how a stock can increase in value, the net asset value (NAV) of your mutual fund can go up. When you decide to sell all or part of your share in the mutual fund, this increase would be your profit.

Choosing the right mutual fund

Mutual funds are sold by prospectus only. This offering document contains very detailed information about the fund. An investor must read this document carefully before investing. With countless options and a number of things to keep in mind, like expense ratios, it’s no wonder that many people seek help finding the right mutual funds to invest in. While it generally takes less effort than following and evaluating individual stocks, it still isn’t easy. If you’d like to learn more and discuss your priorities, please reach out and speak with a NYLIFE Securities financial services professional.