If you don’t know a whole lot about mutual funds, you may have heard of them because of your employer-sponsored retirement plan. But, beyond that, you might wonder what these funds are really all about.
Don’t worry – these funds might seem abstract or complicated, but they are actually simple.
In this post, we’ll gain a better understanding of what mutual funds are and how they can be a powerful wealth-building tool.
What Are Mutual Funds?
Mutual funds are investment vehicles in which a group of investors purchases shares. Fund managers carry out various tasks, such as selecting investments, trading, and rebalancing.
Each share in a mutual fund is split into pieces that invest in dozens or even thousands of publicly-traded companies. As those companies grow, so, too, does the value of the mutual fund.
Because mutual funds have fund managers who actively manage them, they often try to beat a given benchmark. This may be the S&P 500 or Dow Jones Industrial Average (DJI).
Essentially, the word “mutual” here means mutual benefit. All of the investors benefit as their money grows, and fund managers collect an expense ratio as compensation.
There are many different mutual funds, and most of the major brokerages have their own. And as mentioned earlier, your employer-sponsored retirement plan (if you have one) likely invests in these funds.
Mutual funds often come with lower fees and much lower minimums when compared to a human financial advisor. Most mutual funds are broadly diversified and are a great wealth-building tool in the long run. Just be sure you know what your fees are.
If you have an employer-sponsored retirement plan and aren’t sure what your fees are, ask your benefits office for more information.
Types of Mutual Funds
Huh, you mean there is more than one type of mutual fund? As it turns out, there are.
But fear not, because that doesn’t make things much more complicated.
Those of us in wealth-building mode equate mutual funds and stocks. But while mutual funds can contain stocks, they can also contain bonds and money market funds.
Let’s cover them in more detail.
Stock funds invest in shares of publicly-traded companies. Think Amazon (AMZN), Tesla (TSLA), and Microsoft (MSFT).
There are many different types of stock funds, such as:
- Total-market funds track the entire stock market.
- Large-cap, mid-cap, and small-cap funds track companies of different market caps.
- Value funds track companies that are currently undervalued.
- Growth funds track companies that have high growth potential.
- Income funds pay regular dividends.
- Real estate funds invest in publicly-traded real estate companies.
As you can see, this alone is a big topic. Dozens of strategies can come from investing in different types of stock funds.
However, if you invest in mutual funds with your employer, you are likely investing in funds that track most or all of the market, thus lowering risk.
Bond, like James Bond? Unfortunately, Bond funds aren’t quite that exciting. Still, they can be useful for your portfolio.
Bonds are different from stocks, which give you a stake in the issuing company. Bonds, on the other hand, are a type of loan that the issuer agrees to pay on the maturity date – with interest.
Because bonds are a form of a loan rather than an ownership stake, you can invest in government bonds, for example.
Indeed, many popular bond funds are heavy on government bonds. This makes them a hedge against market volatility since governments have a very low risk of default.
With that lower risk usually comes lower returns on average, however.
Money Market Funds
Money-market funds have even less risk – and lower returns – than bonds. These funds only invest in high-quality, short-term investments from governments and US corporations.
Oftentimes, brokerage accounts will sweep any cash you don’t invest in a money market fund. For example, Fidelity uses its SPAXX fund for this purpose.
If you take a look at SPAXX, you will see that the fund invests mostly in US Treasury bills and U.S. government repurchase agreements. These are very low-risk investments.
Money market funds are also highly liquid and usually FDIC-insured, making them a safe and convenient place to hold your cash.
Target-date funds hold a mix of stocks, bonds, and other investment types. These funds seek to make things easier for the average investor.
They do this by changing your target allocation over time, as you inch closer to retirement. As such, they will usually have a year attached to them, such as “target date 2050.”
These funds also rebalance your investments for you, so it’s completely hands-off.
Benefits and Drawbacks of Mutual Funds
Mutual funds have plenty of benefits, but that doesn’t mean they are perfect. Here are some of the benefits and drawbacks of mutual funds:
- Diversification. Most mutual funds are inherently diverse, investing in a large number of companies. This lowers your risk without having to spend time buying shares in each company.
- Dividends. If some of the companies your mutual fund includes issues dividends, you will also receive them.
- Capital gains. If a sells new securities at an increased price, there is a capital gain. Investors receive a cut of that (less capital losses).
- Lower fees. Many mutual funds have lower fees than you would pay a financial advisor.
- Not without risk. Although mutual fund are less risky than individual stocks, that doesn’t completely eliminate risk. If the entire stock market takes a dive, your mutual fund may, too.
- You don’t control investments. If you would rather not pick your own investments, this can be a good thing. But investors who like more control may go elsewhere.
Where to Buy Mutual Funds
You can have mutual funds in your 401k or similar plan, IRA, or brokerage account. If you already have a retirement account through your employer, it likely invests in mutual funds.
You can also open an IRA or brokerage account through a brokerage like Vanguard, Fidelity, or Schwab. Plenty of popular funds are on those platforms.
What Should My Fees Be?
First, a note: mutual funds can be either actively-managed or passively-managed. Unsurprisingly, actively-managed funds have higher fees.
For actively managed funds, typical fees range from 0.5% to 1%. For passively-managed funds, 0.2% is more typical. VTSAX, the largest mutual fund in the world, has a 0.04% fee.
There is no threshold where fees become “too high.” Of course, the lower the fees, the better.
That said, some investors prefer to stay under 0.5%. If your fees are higher, you may want to check fund performance. Numerous studies have shown that even most professional fund managers fail to beat the market.
If the mutual funds you are considering are a part of your employer-sponsored retirement plan, you may have little control over them. However, you may be able to talk to benefits office if your retirement plan invests in high-fee funds that don’t have the performance to justify them.
If all else fails, you can always invest more in an IRA or brokerage account. Just be sure you are getting your full match, if one is offered.
There are many types of mutual funds, such as stock funds, bond funds, and money market funds. And you can hold them in your 401k, IRA, or a brokerage account.
All mutual funds have some level of risk. Generally, the higher the risk, the higher the return. And the reverse is also true.
Mutual funds allow you to pool your money with other investors, allowing you to easily invest in companies with higher share prices. Plus, mutual funds tend to be diverse and often have low levels of risk.
However, there is still some risk, and you don’t have control over the investments.
Be mindful of your fees, and try to keep them as low as possible. High fees can eat away at your returns.
Above all, don’t wait to start investing. If you need a good way to start a brokerage account or IRA, give the M1 Finance app a try.