What is a mutual fund?

What are mutual funds and how do they work?

In simple terms, mutual funds are an easy way for individual investors to participate in the market because they allow you to buy multiple assets, such as stocks and bonds, a little at a time. Mutual funds pool the money they receive from participating investors and use it to purchase assets that meet the fund’s objectives (aggressive growth, total yield, multi-sector, etc.). A professional fund manager typically oversees how the funds are invested and shares any dividends, profits, or losses with all investors proportionately.

Are there different types of mutual funds?

Mutual funds have become so popular that there is an almost endless number and variety to choose from. Depending on your needs, you can select funds based on their objectives, risk profile, expenses, management style, and industry focus—just to name a few. While it’s impossible to list every category available, here are a few of the most common types of mutual funds:

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. Value funds rise or fall in value with the performance of the underlying stocks.

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. Growth funds rise or fall in value with the performance of the underlying stocks.

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 may be less volatile than some other funds because they are diversified over the range of stocks comprising the index, and they are easier to manage, which leads to lower operating costs and fees. They are also subject to market risk.

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. Bond funds are subject to interest rate risk since the value of existing bonds declines when rates rise.

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. Income funds are subject to interest rate risk since the value of existing bonds declines when rates rise.

Target-date funds are funds that are designed to achieve their objectives by a specific date (the target date). In most cases, these dates coincide with a significant financial event such as sending a child to college or entering retirement. In many cases, these funds are set up so that their investment mix becomes more conservative the closer they get to the date when you intend to use the money. Target date funds are subject to the same risks as the underlying stocks and bonds, including market risk and interest rate risk.

Are mutual funds tax free?

A mutual fund is not “tax-free” unless the name or official objective or strategy indicates that it invests in “tax-exempt” securities. Unless the funds are held in a tax-qualified retirement account like an IRA or 401(k), you’ll pay income taxes on any dividends or income you receive each year. (Income from some bonds such as municipals bonds and Treasury securities may be exempt from certain income taxes). You will also pay capital gains taxes on any profit the mutual fund makes each year, or when you decide to sell some, or all, of your shares in the fund itself. Since calculating these taxes can be tricky, and in some cases the alternative minimum tax may apply, it’s always best to consult a tax professional before taking any action.

Are mutual funds FDIC insured?

Unlike bank accounts, which are insured up to certain account limits, mutual funds are not FDIC insured. In fact, a mutual fund’s’ 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?

Mutual funds are subject to the same risks as the underlying stocks or bonds. Mutual funds may achieve greater diversification than most investors can achieve when buying stocks or bonds directly, but that diversification does not eliminate the risks of investing. Since your fund may be invested in 50 –100 stocks at one time, a single poor performer will have less of an impact on your portfolio. Of course, some mutual funds are riskier than others so you need to weigh your options carefully before investing.

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

Exchange-traded funds (ETFs) are like mutual funds because they hold many different assets and help you diversify your portfolio. One of the major differences, however, is that ETFs act more like stocks in that they are actively traded throughout the day, so their price can change rapidly. The value of ETFs can be affected by market factors other than the value of the underlying stocks or bonds, another factor that differentiates them from mutual funds.

Why are mutual funds popular?

Mutual funds are popular because they give the average investor an easy way to diversify their portfolio. This risk-management strategy helps reassure nervous investors who may be worried about “putting all their eggs in one basket.” Mutual fund investors know that their investment is less vulnerable to the fluctuations of an individual stock. Nevertheless, even a highly diversified mutual fund is subject to market risk.

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 vastly 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
• Liquidity—shares can be purchased or redeemed on any business day at the net asset value, which may be more or less than the original cost.
• Easily purchased on most investing platforms
• Professionally managed
• Wide variety of choices

Mutual fund drawbacks:

• Fees and expenses
• Comparing funds can be difficult
• Can only trade at the end of the day
• Risk—mutual funds are subject to the same risks as their underlying investments.

How to start investing in a mutual fund

Purchasing shares in a mutual fund is an easy, straightforward process. In most cases, you don’t have to have a brokerage account—you can buy and sell mutual funds from your computer or phone. Just 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 buy a mutual fund?

You can often start a mutual fund with as little as $50 a month. You can purchase shares in a fund through an online brokerage account or by contacting the investment company directly. From start to finish, it could take you as little as 15 minutes to set up. 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 as pending until after-hours.

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

One thing to keep in mind before you get started is that there is usually a mutual fund minimum investment that’s somewhere between $500 and $5,000. The good news is that some fund families will waive that minimum if you sign up for automatic investments. Not only is this a great way for new investors to get started, but it can also help you take advantage of a systematic investing strategy known as dollar cost averaging. Note: A program of regular investing does not ensure a profit or eliminate the risks of investing. In addition, many companies 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 in the form of fees. These fees typically range from 0.05% to 1.5% of your account value and are often referred to as the expense ratio. While this number seems small, over time these fees can have a dramatic impact on your investment returns. 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, (called loads), that you have to pay whenever you buy or sell them.

Mutual fund returns

While negative performance periods are inevitable, the long-term historical performance of the U.S. stock and bond market has generally been positive. For example: U.S. large-cap stock mutual funds generated an average annual return of 12.54% over the last 10 years.¹ Annual returns are produced whenever a mutual fund increases in value through dividends, capital gains, or an increase in the net asset value (NAV). However, please keep in mind that market or index performance is not indicative of how your mutual fund will perform, especially if it is an actively managed mutual fund and not an index fund.

—Dividends are profits generated within the mutual fund that are passed on to the shareholders as cash or that can be 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.

—Net asset value (NAV) is what determines the price per share of a mutual fund. It can go up and down like a stock, and any increase that happens after you purchase your shares would be considered profit.

Choosing the right mutual fund

Mutual funds are sold by prospectus only. This offering document contains 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 usually 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.

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¹“Share of Households Owning Mutual Funds in the United States from 1980 to 2021,”  Statista.com, June 2022.

Investments are offered through NLYIFE Securities LLC (Member FINRA/SIPC), a Licensed Insurance Agency and a New York Life Company.