Mutual fundsMutual funds buy a bunch of different securities. Investors, in turn, buy shares of the funds. There are thousands of funds that buy lots of different things, but most of them simply own stocks or bonds or a combination of the two. Others focus on specific sectors such as commodities, REITs, technology companies or even currencies.
One particular type of mutual fund has soared in popularity in recent years: the index fund. An index is a benchmark for the market as a whole. For instance, the Standard & Poor's 500, made up of 500 large-cap stocks, can be mimicked by index funds that hold roughly the same positions in the same proportions. "The larger the company, the more they're represented in the index," says Flower.
Actively managed funds are run by a manager or a team of people who follow a particular investment strategy. They pit their investing skills against a benchmark.
"Index funds outperform some 80 percent of the actively managed funds," says Brosious. "Over the long term they will outperform."
Advantages and disadvantages of mutual finds
- "You can get instant diversification with as little as $50 or $100," says Kirk Kinder, CFP and owner of Picket Fence Financial in Bel Air, Md. That is, if you're in an automatic investment program.
- Diversification mitigates risk. For instance, by spreading money over a bunch of stocks, the effect of one poorly performing company can be negated by the other positions.
- Additionally, the burden of researching companies falls to the fund manager if it's an actively managed fund. Investors benefit from analysis by the manager or the team. "You do get professional management if that's what you want -- or low-cost management with index funds," says Kinder.
- Convenience also factors into mutual funds' popularity. "Most people elect to have their dividends and capital gains reinvested, and most mutual funds will do it for free; they just roll it right back into the fund," says Brosious.
- The expenses can add up. Some expenses to look out for include the expense ratio and the sales fee or "load." The expense ratio is stated as a percentage of the fund's net assets and is deducted from your returns. "The average annual expense for a mutual fund is about 1.5 percent, depending on which mutual fund you're in," says Brosious. Obviously, that eats into your bottom line, and over time it can make a big difference.
- Buying a no-load fund can bypass the issue of sales fees altogether, but one thing that can't be avoided are taxes if the funds are held in a taxable account. "Mutual funds are not very tax-efficient," says Kinder. "One reason is the portfolio turnover." Every time the fund manager sells one of the underlying positions, shareholders can be exposed to a capital gains tax if the trades are profitable for the fund.
- "A second reason. and this is even for index mutual funds: You can end up paying taxes based on the actions of other shareholders," says Kinder. "In order for me to sell a mutual fund share, the manager may have to sell some of the underlying positions, let's say GE or Disney, to give me my money. The capital gains created by that sale aren't just passed to me directly, but they're passed to all of the shareholders equally. So if I'm selling, you may end up paying a fortune in my capital gains taxes."