Depending on your financial objectives, mutual funds can be an essential tool for achieving long-term wealth. While they tend to have higher fees and more investment requirements than exchange-traded funds, their legacy status appeals to many investors.
What is a mutual fund and why should you consider investing in them?
Mutual funds are investment vehicles that allow you to own a portfolio of stocks, bonds or other securities. When you buy a share of a mutual fund, you own a tiny fraction of all the assets in that fund.
For retail investors, the most common reason to buy mutual funds is diversification. Owning various investments minimizes the risk of having too much exposure to a single asset.
For example, when the stock market drops, safe-haven assets like gold or bonds tend to go up. A well-diversified portfolio gives you peace of mind, especially if your goal is to build wealth over time.
Apart from diversification, mutual funds are a cost-effective means to streamline the process of investing. Through these managed funds, you let a professional do the work for you.
Actively managed vs. passively managed funds
Mutual funds can be classified as either passively or actively managed.
In a passively managed strategy, a fund manager aims to replicate the performance of a broad benchmark like the S&P 500. Through one of these investments, you essentially own all the equities that make up the index. This process eliminates the need for fund managers to select individual companies at their discretion. Therefore, management fees are usually low.
With actively managed funds, money managers buy and sell assets when they find an opportunity — as long as those investments align with the funds’ strategy. The goal here is to produce higher returns than one would achieve by simply following an index. As a result, these funds typically come with higher fees and can exhibit greater volatility than passively managed funds.
When building your portfolio, the key is to keep fees low and remain diversified. The more you can minimize unnecessary expenses, the more you can invest toward your financial future.
How can you invest in mutual funds?
For the do-it-yourself investor, buying mutual funds can be done at low or no cost.
Automated investing has also made buying mutual funds simple. Robo-advisors automatically re-align asset allocations as part of their service based on investors’ profiles.
Many investors are still most comfortable working with a financial advisor. Of course, that personalized attention may come with a fee. Nevertheless, many brokers offer free resources, which may include complimentary consultations with a financial planner.
When you are ready to invest in mutual funds, make sure to review if there are minimum initial investment requirements, the types of operational fees you’ll pay and any clauses related to pulling money out.
For example, certain mutual funds have early redemption fees or even load fees. A load fee is a commission an investor pays when buying or selling mutual funds. Mutual fund companies and their intermediaries determine these fees.
In the long run, fees are an essential consideration for investors as they reduce your returns.
All the information you need about a specific fund is available in the fund’s prospectus. Take the time to review it in detail, and make sure you are comfortable with all the conditions.
As with most investments, mutual funds are susceptible to losses. The magnitude of potential losses is tied to the level of risk contained in the portfolio. So, a fund that invests heavily in riskier assets like emerging technologies will have a very different risk profile than a fund that invests in established, tried-and-true names.
Before you get started, here are four steps to follow:
- Determine your financial goals: The type of investments you choose depends on what you are trying to achieve. For example, someone about to retire will likely have a different asset allocation than someone who’s just out of college. So, always let your financial objectives drive your decision-making.
- Research mutual funds: When selecting mutual funds, pay attention to factors like expense ratios, the fund’s past performance, trading volume, top holdings, fund flows and the net asset value.
- Outline your asset mix: Before investing, do an inventory of what you own and how you want to allocate your assets. Remember, one key is to remain diversified.
- Know what you own: By periodically reviewing your investments, you can take charge of your finances and make any adjustments needed. Utilize any free resources from your broker, like meeting with a financial planner, and always ask questions. Ultimately, there’s no such thing as a hands-off investment.
Types of mutual funds
There’s an abundance of mutual fund categories available to retail investors. These are built to help you achieve different financial objectives, such as retirement.
Below are some of the main categories fund investors can choose from:
These funds invest in domestic or foreign equities. Some follow a broad benchmark in a passively managed strategy, while others are actively managed, relying on a fund manager’s ability to pick stocks. In general, they are categorized based on an investment style such as growth or value. Company size also plays a factor, with large-cap companies having more established profiles than mid- or small-cap names.
One of the most popular types of mutual funds, bond funds invest in many different individual bonds, and income payments are generally made monthly. Bond funds can also be categorized by the type of bonds they invest in, for instance government or corporate debt. Considered a safer investment than equity funds, bond funds offer better yields than standard savings accounts.
These funds aim to replicate the performance of a broad benchmark like the S&P 500 or the Nasdaq 100. Index funds provide instant diversification and often carry lower fees than actively managed funds. Additionally, these investments don’t rely on a fund manager’s ability to pick winning stocks. The mantra of index investors is “If you can’t beat em, join em.”
Money market funds
Considered low-risk, these funds usually invest in U.S. Treasury bills, certificates of deposit (CDs) and other cash equivalents. They offer better returns than your typical savings account, but your investment is not insured by the Federal Deposit Insurance Corporation (FDIC).
Through this investment, you get access to a mix of stocks, bonds and money market funds. Also known as asset allocation funds, they provide tailored strategies aimed at delivering a combination of growth and income.
These managed funds change their asset allocations based on your expected retirement age, selecting more conservative assets as you get older. The key with target-date funds, and any other fund for that matter, is to review the contents of the fund and ensure the strategy aligns with your financial objectives.
Mutual funds can help you reach your investment goals. There are many reasons to own them, including diversification and convenient access to various investment strategies.