A mutual fund is an investment vehicle that gives you access to a diversified, professionally-managed portfolio.
Table of Contents
- What Is a Mutual Fund?
- How Do Mutual Funds Work?
- What Are the Best Mutual Funds?
- Investing in Stocks vs. Mutual Funds: What’s the Difference?
- Advantages of Mutual Funds
- Disadvantages of Mutual Funds
- Tax Implications: Mutual Funds vs. ETFs
- What Types of Mutual Funds Exist?
What Is a Mutual Fund?
A mutual fund is a pool of investor money that a fund manager allocates on behalf of those investors.
Depending on the fund, its purpose can be to produce capital gains or income. All of the mutual fund’s shareholders get proportional gains or losses based on how much money they put into the fund.
These funds can be actively or passively managed with a wide range of investment strategies.
Mutual funds charge annual management fees called “expense ratios” and sometimes “sales loads” (commissions to buy and sell). The expense ratios can vary pretty significantly.
You’ll see mutual funds used a lot as investment vehicles within employer-sponsored 401(k) retirement plans.
What Types of Investments Can Mutual Funds Include?
Here are some of the asset classes you may find inside a mutual fund:
- Asset allocation (stocks and bonds)
How Do Mutual Funds Work?
Fees are a major component of long-term return on investment and a key part of money expert Clark Howard’s investment philosophy.
If you’re not terribly familiar with investing, it may surprise you to learn that active funds that attempt to beat the market not only cost more but also often underperform: a double whammy.
The more transactions a fund makes, perhaps chasing the latest trends or trying to squeeze out some extra returns, the more fees you’ll probably end up owing the fund manager. The more you dive into investing history and strategy, the more you understand that it takes rare skill (and sometimes luck) to outperform the market.
The best mutual funds are often index funds, at least if you subscribe to the philosophy of Clark and many others. Index funds are passively managed and are designed to track financial indexes. I’ll dive into the different types of mutual funds in detail later in this article.
Not too long ago, you’d have to pay a commission to buy stock through a broker or investment company. Now, many of the biggest brokerage firms offer commission-free trades for stocks and exchange-traded funds (ETFs). The same is true for mutual funds. Commission-free mutual funds are sometimes called “no-load funds.”
How Do I Invest in a Mutual Fund?
Investing in a mutual fund is straightforward.
Here are the relevant steps:
- Enter the ticker symbol of the mutual fund in which you want to invest.
- Determine how much money you want to invest in that fund. Keep in mind some mutual funds include minimum requirements.
- Submit your trade request and wait for it to get filled. Mutual funds calculate their daily share values at the end of each business day. The fund will fill your order at that time based on the price.
The fund’s holdings may generate dividends. You may need to decide whether you want to reinvest those dividends into additional shares or if you want the dividends distributed to you as cash.
If you’re investing in a mutual fund through your 401(k), you’ll be able to choose the fund or funds that you want through your 401(k) plan administrator.
What Are the Best Mutual Funds?
As with most investment decisions, the “best” mutual fund for you may not be the best for someone else.
There are a lot of circumstances that impact the answer to this question including the make-up of your current portfolio, your goals, your timeline, whether you’re investing inside of a retirement account and how much effort you’re willing to put into monitoring your portfolio.
Clark says the most important criteria is how long you’re able to leave the money you’re investing in the market before you need it. He recommends being able to invest for a minimum of five years if you’re going to consider putting money into a mutual fund.
Fidelity, Schwab and Vanguard all offer Clark-approved mutual funds.
However, if Clark has to choose a single group of mutual funds that he thinks will work well for the most people, it’s the Fidelity Zero Index Funds:
- Large Cap Index Fund (FNILX)
- Total Market Index Fund (FZROX)
- International Index Fund (FZILX)
- Extended Market Index Fund (FZIPX)
“Simply by putting money in the Fidelity Total Stock Market Zero and the International Zero would give somebody incredible diversification and cost them nothing in commissions or expenses,” Clark says.
“And there’s no minimum [investment]. So if you ask me what is the starter fund that’s appropriate for someone who’s got a little bit of money or a lot of money, the Fidelity Zero funds fit — but only if they have a long time horizon.”
Investing in Stocks vs. Mutual Funds: What’s the Difference?
You can lose money investing in a mutual fund just as you can lose money in a stock. But you reduce the variance of possible outcomes with the diversification a mutual fund offers.
If you flip a quarter, you’ve got a 50% chance of landing on heads and a 50% chance of landing on tails. If you flip the coin 10 times, the chances of variance — say, the coin landing on heads 10 out of 10 times — are much greater than if you flip the coin 100,000 times.
The same is true with investing. Putting all your eggs in one basket can potentially allow you to generate unusually strong returns. But it can also allow you to lose big. Whereas with the right sort of diversification, you can give yourself great odds at solid long-term gains while reducing your risk big-time.
Advantages of Mutual Funds
Here are some of the strongest benefits of investing in mutual funds:
- Instant diversification. One of the best ways to get access to a large number of stocks without buying at least one share of each of them is through a mutual fund.
- Affordable (passively managed). There are three ways you get charged by mutual funds: taxes, commissions on trades and expense ratios (annual fees you pay to the fund manager). The expense ratio and tax bill should be much more affordable in a passively managed fund such as an index fund, which is a type of mutual fund.
- Outsource day-to-day investing work. A professional fund manager will constantly monitor your portfolio, adjusting when necessary. You still have to choose which fund to invest in, but mutual funds can be relatively low-effort ways to invest.
- Plentiful options. No matter what investing style and strategy you prefer, there’s a fund for it. It’s like one of those all-you-can-eat Vegas buffets where every type of food is available to you.
Disadvantages of Mutual Funds
Here are some of the drawbacks to investing in mutual funds:
- Tax headaches. I’ll discuss this in detail shortly. But if you invest in mutual funds outside of retirement accounts, know that your tax bill will take a hit, especially in good years for the market.
- Expensive (actively managed). Fund managers who conduct a lot of buying, selling and shifting of assets generate bigger expense ratios, and that gets passed along to you as an investor. It also can lead to a bigger tax bill. Although some active funds are able to outperform passive funds, in general, passive funds usually win over the course of time.
- Naturally capped gains. The more diversified your portfolio is, the less possible it will be for it to produce outsized gains. You’re trading some of the potential upside for less risk and more stability.
- Lack of control. You’re handing the keys to the fund manager in terms of investment decisions. If there are certain companies or industries in which you’d rather not invest, you’ll have to be careful which mutual fund you buy into.
Tax Implications: Mutual Funds vs. ETFs
The bottom line is that ETFs are more advantageous than mutual funds when it comes to taxes.
Of course, that matters only if you’re investing in funds outside of a tax-advantaged retirement account (such as a 401(k) or an IRA).
You can buy ETF shares on the open market. But you typically buy mutual fund shares through a fund manager. Fund managers buy and sell assets within the fund to fulfill orders, creating more transactions than you get with ETFs.
Mutual funds also must distribute capital gains (which can even be short-term gains taxed at a higher rate). The IRS will tax mutual fund shareholders on any dividend received through the fund, even if you reinvest it.
Again, none of these dynamics matter if you’re investing inside of a retirement account. But mutual funds can create tax headaches in taxable investment accounts.
What Types of Mutual Funds Exist?
There’s a mutual fund that fits every investment philosophy and strategy.
Each mutual fund must offer a prospectus, which provides information about its investment objectives. You can find out:
- Its goal (capital appreciation, income or both)
- Associated fees and expenses
- Historical performance
- Name of and information about the portfolio manager or managers
- Strategy information (example: dividend distribution offerings)
Here are some of the most common types of mutual funds:
- Stock funds: Your 401(k) plan likely is filled to the brim with these. They’re often categorized as domestic or international, by the size of the companies in which they invest (small-, mid- or large-cap) or by their investment approach (growth, value, etc.).
- Bond funds: Often actively managed, these funds tend to seek out undervalued bonds to sell for a profit.
- Index funds: These funds track the assets in the underlying index. A common example is a total stock market index fund.
- Target date funds: This is Clark’s go-to retirement investment recommendation. These funds reallocate your portfolio over time, slowly removing risk the closer you get to your “target” retirement year.
- Asset allocation funds: These funds hold multiple asset types (stocks and bonds, for example).
Mutual funds are especially effective vehicles inside of retirement accounts. In fact, target date funds are Clark’s most common investment recommendation, followed closely by index funds.
If you want to invest in an index fund outside of a retirement account, strongly consider buying the ETF version of the fund. ETFs hold tax advantages over mutual funds.