Collectively, mutual funds own about 20% of the stock market. That’s more than pension funds, more than government retirement funds, and more than international investors. With the U.S. stock market now worth $30 trillion, mutual funds are investment behemoths, purchasing both specialized sectors and indexes, as well as acquiring shares across a broad market spectrum. Mutual funds also purchase bonds and other securities, sometimes even mixing investment types within one fund.
A recent study of mutual fund investors showed a median household asset value of $200,000 among mutual fund owners, with most of those investors holding more than half of their financial assets in mutual funds. More than one-third of mutual fund investors purchased their first mutual fund through an employer-sponsored retirement plan, such as a 401(k).
Mutual fund ownership
What is a mutual fund?
You can think of a mutual fund as a pooled investment. A mutual fund combines your investment with those of other investors to purchase a collection of stocks, bonds, or other tradable securities.
This collection of securities purchased by the mutual fund is called a portfolio. Mutual fund investors own shares in the fund as opposed to directly owning the securities purchased by the fund. The price of these mutual fund shares fluctuates daily based on the value of the securities held within the mutual fund’s portfolio.
Mutual funds provide an easy way to enter the world of stock market investing, as well as access to some other types of investments that are held by mutual funds, such as bonds, and provide access to markets not readily available to individual investors. Investing in individual stocks or bonds requires a thorough understanding of valuations and often a keen sense of relevant market changes. Mutual funds promise to do all or most of that heavy lifting (and thinking) for you, as many mutual funds are actively managed by investment experts who choose which securities to purchase, which to sell, and when.
The convenience of having someone else manage investment strategy and timing — as well as providing access to markets in which individual investing may be difficult — does come at a price. Mutual funds include various fees and structures that can prevent the performance of a mutual fund from mirroring the investment performance of the securities held within the fund. In simpler terms, a mutual fund takes small bites — or sometimes not so small bites — out of your investment, which can add up over time.
How to choose a mutual fund
In many cases, mutual fund investors choose their fund based on the recommendation of an investment advisor or because they’re familiar with the name of the company sponsoring the fund.
In the case of a 401(k), your mutual fund choices are often sorted according to your preferred risk level or by expected performance versus the broad market. In both of these cases, your choice is often simplified, without much discussion of the various fees and expenses that can affect the long-term performance of your investment.
Similarly, the various types of funds may not be discussed in detail if using a broker recommendation or investing through a 401(k) or an IRA. If you’ll be purchasing mutual funds on your own, there are some industries specific terms you’ll need to understand.
Closed-end mutual funds
Where many mutual funds can issue new shares, a closed-end fund issues a fixed number of shares which are then traded on the open stock market. There are literally hundreds of closed-end mutual funds available for trading on the U.S. stock market, spanning common investments like stocks and bonds, but also sometimes specializing in certain commodities.
Closed-end mutual funds are actively managed, with fees sometimes higher than with other types of mutual funds due to a limited amount of shares. In many cases, these fees are priced into the trading value of the mutual fund shares.
Closed-end investment objectives
Open-end mutual funds
Most mutual funds are open-end funds, which means that the fund can issue new shares as needed, allowing a larger pool of investors to participate in the fund. When a fund’s investment management team or investment manager determines that a fund might no longer meet its stated investment objective if it continues to grow larger, that fund can be closed to new investors. In some cases, the fund can also be closed to new investment from existing fund investors.
Open-end mutual funds usually provide more liquidity than some smaller closed-end mutual funds, but may also provide a smaller potential for gains. Due to liquidity risk for closed-end funds and its effect on pricing volatility, open-end funds are generally considered to be safer then closed-end funds.
Load vs. no-load mutual funds
Among the more mysterious terms used in mutual fund investing are “load funds” and “no-load funds”.
A load is a fee that is charged either on the purchase of mutual fund shares or upon the sale of mutual fund shares. A load charged upon the purchase of mutual fund shares is a front-end load, while a load charged upon the sale of mutual fund shares is called a back-end load, sometimes also referred to as a contingent deferred sales charge (CDSC).
Many funds do not charge a load at all, and these are called no-load funds. Vanguard, one of the largest mutual fund providers in the market, built its name in large part on no-load funds. One of its well-known funds, the Vanguard 500 index, is now into its fifth decade of trading.
For load funds, the load is charged in addition to annual expenses and management fees, and is usually divided between the mutual fund company, the brokerage, and the individual broker who sold the fund to the client. In that regard, it’s similar to the commission you might pay when selling a house. In effect, the load is a sales charge that helps to compensate your advisor.
If you’re purchasing a mutual fund without the help of a broker or advisor, a no-load fund may be a better value because it doesn’t reward a commission for research you did on your own.
Index funds vs. actively managed funds
Mutual funds can be either actively managed, leveraging the market insight and investment acumen of a management team, or they can take a simpler form that largely tracks an index. Choosing between the two types of funds, actively managed versus passive, is a matter of preference, depending on your investment goals and your comfort level either in the ability of the fund manager or in the longer-term trend of a market index..
On paper, you can find advantages and disadvantages for each type of fund. Historically, broad market indexes have provided higher returns than most actively managed mutual funds. There are, of course, exceptions. A handful of actively managed mutual funds have beat the S&P 500 index for the past 10 years. However, many of these funds are closed to new investors.
Expenses, loads and trade timing can affect the overall performance of an actively managed fund. On the other hand, an actively managed fund might help to protect your downside because fund managers aren’t paid to lose money. This creates an incentive to reduce holdings in underperforming securities, either moving assets to cash temporarily or reinvesting in other opportunities.
Owning shares in an index fund, which is not an actively managed fund, can mean that during prolonged market corrections or even crashes, the value of your fund shares can fall dramatically because the fund simply tracks a given index within the market. If the index goes down, so does the value of the shares.
The modern mutual fund market provides something for everyone from niche funds to broad index funds to specialized index funds, and of course, actively managed funds. Some segments or funds tend to be more volatile than others.
If you’re a young investor, volatility isn’t necessarily a bad thing, provided the overall trend is upward. In the long run, markets tend to recover and even prosper. If the value of a mutual fund drops too far, the mutual fund company might choose to dissolve the fund or to transfer the assets of the poorly-performing fund to a larger fund. Mutual funds, because they tend to be well-diversified or follow a market index, are unlikely to go to zero like an individual stock can.
If you’re closer to retirement age, volatility might not be as kind to the value of your mutual fund shares, which is an important consideration if you might need to access the value of your mutual fund investments in the near future.
When researching historical returns for a mutual fund, the headline numbers for recent returns can be a distraction. Returns for a short time period, whether positive or negative, can be an aberration or even a possible indication of volatility.
A well-established fund will be able to demonstrate returns over a longer time period of five to ten years or even longer, helping to guide your decision based on long-term performance. As you’ll commonly see in industry advertising, past performance does not guarantee future performance.
Every fund can have a great, bad, or mediocre year, and management teams responsible for past successes can change, making past performance statistics a tool that you can use to help you choose a fund, but not a guarantee.
Mutual fund historical performance
Benefits of mutual fund investing
Mutual fund investing is generally considered to be a safer way to invest in the stock market, bond market, or to gain trading exposure to other types of securities than investing directly in these markets. In many ways, mutual funds simplify investing either by tracking a broad index or a smaller index or by providing active management by investment experts.
The average investor is often too busy with work, family and other responsibilities to watch markets closely and to keep tabs on industry or company-specific changes that can affect the value of investments. This is what fund managers do, and that does provide value.
Additionally, mutual funds provide diversification. Many individual stock investors have suffered horrific losses because investments were heavily weighted in a specific sector or even an individual company. It’s entirely possible for individual investors to invest a dollar and only get back 50 cents. Because mutual funds are usually more diversified — and actively managed in some cases — that type of loss is much less likely.
Another benefit of mutual fund investing is access to markets or individual securities to which you may not have easy access as an individual investor. Because you are buying shares in the mutual fund as opposed to shares in the underlying equities or buying other securities that the mutual fund holds, you can buy very small pieces of companies. For example, through mutual fund investing you can gain investment exposure to stocks like Google, currently over $1,000 per share, which might be more difficult to purchase individually due to a higher-than-average share price.
How to buy mutual funds
Mutual funds can be purchased through a broker, either online or locally if you prefer a brick-and-mortar business. Many mutual fund companies also allow direct investment, without using a broker as an intermediary. In either case, minimum balance restrictions may apply, with additional fees common if your investment balance falls below a specified value. In some cases, like with vanguard, you can avoid minimum balance fees by opting to manage your account online only.
Certain mutual funds do not provide an option to purchase directly, selling shares in the funds only through certified financial planners. In these cases, it’s likely that these funds are load funds to provide commission to the advisor. However, each mutual fund has its own fine print, so what’s true for some may not be true for all.
Price of entry
If you’re just getting started in mutual fund investing, you might be looking for a way to dip a toe into the water rather than getting in over your head. Many mutual fund companies require a minimum amount as an initial investment, but this minimum varies widely from as little as $100 up into the thousands.
Many mutual fund companies now offer automatic investment programs (AIP), which automatically withdraw a fixed amount from your bank account each month and invest that amount in the fund or funds that you’ve designated. This provides the benefit of dollar cost averaging combined with the diversification offered by mutual funds. If your chosen mutual fund is actively managed, you’ll also benefit from the market experience of your fund’s management team.
Dollar cost averaging is simply a method of investing consistently over time, without regard to short-term volatility. If the price of the shares in your mutual fund go down in the short term, you’re able to purchase more shares for the same investment amount. Later when those shares rise in value, you’ll have gains against more shares.
In effect, dollar cost averaging — and mutual funds in general — are a way to actively participate in investment markets without the pressure of trying to time highs and lows in the market with sales and purchases. Over time, both dollar cost averaging and mutual fund investing tend to provide the most reliable returns for many investors. For average investors, there’s something to be said for the set-it-and-forget-it approach that both often have in common.