What is a Mutual Fund?

A mutual fund is an investment vehicle that pools money from many investors, including individuals, companies and organizations, to purchase stocks, bonds and other securities. Whether you are a beginner investor or someone looking to diversify your investment portfolio, understanding the basics of mutual funds is crucial.

Different Types of Mutual Funds

There are various types of mutual funds available to investors, each designed to meet different investment objectives and risk tolerance. Some common types include:

• Equity funds: These funds primarily invest in stocks of companies, with the option to focus on specific sectors or take a more diversified approach by investing across various industries.
• Bond funds: Bond funds primarily allocate investments in fixed-income securities, including government and corporate bonds, with the objective of generating consistent income and mitigating investment risk in comparison to equity funds.
• Money market funds: These funds allocate investments into low-risk securities, such as Treasury bills and certificates of deposit, which are known for their short-term nature. Due to their relative safety and liquidity, they are regarded as suitable options for short-term investment purposes.
• Index funds: Index funds are investment funds that aim to mimic the performance of a specific benchmark index, like the S&P 500. They offer broad market exposure and typically have lower expenses compared to actively managed funds.
• Sector funds: Focused on specific industries or sectors, such as healthcare, technology or energy, these funds allow investors to concentrate their investment strategies in a particular area they believe will perform well.
• Balanced funds: Aimed to provide a balanced portfolio, balanced funds, also known as asset allocation funds, allocate funds to investment options with moderate risk expoure, such as investing in a mix of bonds, stocks and sometimes cash equivalents.
• International funds: These funds invest in firms located outside the investor's home country, which provides diversification beyond domestic investments and exposure to global markets.

Investors should consider their financial goals, risk tolerance, and investment time horizon when choosing a mutual fund. Consulting with a financial advisor can provide personalized guidance based on individual circumstances.

How Do Mutual Funds Work?

The reason for this collective approach is that this type of basket of securities — a portfolio — might be tough to recreate on your own. As a result, you want to look into investment opportunities that can provide you with the gains you seek. Plus, you can get a few different characteristics that are difficult to uncover in other places.

Mutual funds can be diverse, and they provide you with benefits that make your investment that much stronger. Here are a few possible mutual fund characteristics:

• Focused on long-term growth
• Focused on short-term growth
• Invested in stocks
• Invested in bonds
• Offers a mix of stocks and bonds

The sky’s the limit when it comes to the different types of mutual fund options you can consider.

Do I Need to Invest in a Mutual Fund?

Whatever your ultimate goals are, the biggest benefit to a mutual fund is that it’s diversified. In other words, there’s less risk involved because of a mutual fund’s giant pool of securities. At the same time, these funds are run by fund managers or experts who can change over time. You want to be sure that you’re investing in mutual funds that make the most sense to you — and that could change at any time.

If one company goes belly-up, other companies in a mutual fund portfolio might still do well; therefore, a mutual fund’s overall net worth, or net asset value (NAV), won’t be as negatively affected. You also might need a mutual fund to achieve specific goals.

Whether you're just learning how to invest in stocks or you’re thinking about retirement, a mutual fund might be worth looking into. If you’ve got a short-term savings goal but can’t risk losing it, you might look no further than a mutual fund.

In addition, if you're not into balancing your portfolio or digging deep to find a particular stock or bond that might provide the cherry on top of your portfolio, mutual funds might be calling your name.

Mutual Funds vs. Individual Stocks

Mutual funds can be a group of stocks, and unlike a stock, mutual funds are diversified because you’re investing in a whole bunch of stocks at once. Standalone stocks are a major investment risk because you’re investing in one versus a whole group of them.

Mutual Funds

• Lower-risk; small investors can invest
• Managed by investment professionals
• Less volatile due to diversification

Stocks

• Higher risk
• Managed by the investor
• More volatile because of no diversification

Opening a Mutual Fund Account: Pros and Cons

Besides diversification, mutual funds offer other benefits. Mutual funds have a few downsides as well.

Pros of Mutual Funds

• Professionally managed
• Liquid
• Can find anything to match what you’re looking for, including risk tolerance and investment horizon
• Make retirement savings simpler

Cons of Mutual Funds

• Management fund fees can be high
• Locked in (depending on the type of fund you invest in, as many as five years)
• Operating expense fees 

Risks Associated With Mutual Funds

Though they’re well-diversified, mutual funds aren’t guaranteed no-risk investments. The level of risk depends on the type of investment fund. Here are a few things you’ll need to know:

• Do research among mutual fund companies to help you determine how much they're making and how their holdings make their money.
• Understand how the economy as a whole is doing and make sure you understand how the companies and industries could be affected by a bull or bear market.
• Research that mutual fund’s past performance.

How to Invest in Mutual Funds

When it comes to research on individual mutual funds, using sites like Morningstar can help. A ticker-symbol-friendly website, Morningstar can help you find new investments and filter out the false information that exists on the internet.

Once you decide which mutual funds you want, you’re going to need a way to purchase them, so you need a broker. This is where a lot of questions arise. Full-service broker? Online discount broker? Which one is best?

Which is Best: Discount or Full-Service?

If you’re trying to decide between a discount or full-service brokerage, there are a few differences — and it depends on what you’re looking for. A brokerage account allows you to buy and sell mutual funds, stocks, bonds and exchange-traded funds (ETFs).

Full-service brokers offer more products and services, including planning for retirement, tax advice and portfolio review. Because services are more comprehensive, typically, fees are higher with full-service brokerages.

If you feel you need more hand-holding, a full-service broker might be what your life is missing. However, if you crave speed and a mutual fund on the cheap, you’re better off with a discount broker. Here are a couple of other things to consider:

• Fees: Fees aren't the only consideration, but they should be a part of your decision-making process.
• Your goals: Your goals should also be a major consideration in your decision to invest in a mutual fund. What is your time horizon? When will you need your money?
• Load/no-load mutual funds: A loaded mutual fund typically charges a front-end or back-end load or cost or a percentage of the amount invested, usually 1% to 5%. It’s a good idea to get a sense of what those fees entail.

Fees for Mutual Funds

Mutual fund fees and expenses involve a sales charge or load, which is the broker’s sales commission. All funds charge annual expenses to cover the fund’s operating costs, which include:

• Management fees
• Advertising and sales expenses (also known as 12b-1 fees)
• Reinvestment fees
• Exchange fees
• Custodial fees
• Distribution/service fees
• General administrative fees

Load and no-load funds are options in purchasing a mutual fund. Front-end loads are the best option for investors who are considering a long-term investment in a large number of shares.

Mutual funds are available in multiple share classes (Classes A, B and C). If you’re purchasing Class A shares, the front-end load offers a lower sales load the more you purchase. Back-end loads are designed for investors who hold on to particular funds for a long time.

Back-end load sales charges happen when the shares are sold. Be sure to check which will be more expensive for you in the long run and determine the combination of Class A, B or C that is the best option for you when it comes to load and no-load funds.

Investment Objectives

It’s important to consider fees, share class, past performance and risk when considering which mutual fund is best for you. Don’t forget to read the prospectus of the mutual funds you’re considering.

You’ll find everything you need to know in the prospectus, from financial statements to the fund's specific investment strategy. Investment objectives and risk must be considered as well. Many mutual funds have outperformed the market for long stretches of time. However, according to a Standard & Poor's research report, 92.2% of large-cap active funds, 95.4% of mid-cap active funds and 93.2% of small-cap active funds have lagged behind index funds that track the S&P 500.

A big reason for falling short is because of mutual fund fees and the fact that some mutual funds make short-term buying and selling decisions, creating more taxable income than a buy-and-hold strategy.

Ready to start investing in mutual funds? Check out Benzinga's picks for the best brokers for mutual funds.

Frequently Asked Questions

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