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What is a mutual fund?

A mutual fund is an investment fund that pools money from many investors (including individuals, companies and other organizations) to purchase stocks, bonds, and other securities. The reason for this collective approach is that this type of basket of securities (otherwise known as a portfolio) might be tough, if not downright impossible, to recreate on your own.

Mutual funds can be quite diverse. Here are just a few possible mutual fund characteristics:

  • Focused on long-term growth
  • Focused on short-term growth
  • Invested in stocks
  • Invested in bonds
  • A mix of both stocks and bonds

(In fact, the sky’s the limit when it comes to all of the different types of mutual funds options you can consider.)

Why might I need a mutual fund?

Whatever your ultimate goals are, the biggest benefit to a mutual fund is that it’s automatically diversified. In other words, there’s less risk involved because of a mutual fund’s giant pool of securities. 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, won’t be as negatively affected.

You also might need a mutual fund to achieve specific goals. If you’re planning on retiring at some point in your life, a mutual fund might be worth looking into. If you’ve got a short-term savings goal but can’t risk losing every penny, 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 which will provide the cherry on top of your portfolio, mutual funds might also be calling your name.

How are mutual funds different than 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 risk because you’re investing in one versus a whole group of them.

Mutual funds Stocks
Lower-risk; small investors can invest Higher risk
Managed professionally Managed by the investor
Less volatile due to diversification More volatile because of no diversification

Pros and cons

Besides diversification, there are several other pros for mutual funds. Unfortunately, mutual funds have a few downsides as well.

Pros:

  • They’re professionally managed.
  • They’re liquid.
  • You can find anything to match what you’re looking for, including risk tolerance and investment horizon.

Cons:

  • Management fees can be high.
  • You’re locked in (depending on the type of fund you invest in, you could be locked in for a required amount of time, like five years).
  • Operating expense fees can also cause your money to take a hit.

Risk

Though they’re well-diversified, mutual funds aren’t guaranteed no-risk investments. The level of risk, as always, will depend on what your investments are. Therefore, there 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 those particular companies 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 look for mutual funds

When it comes to research on individual mutual funds, Morningstar could be your best friend. A ticker symbol-friendly website, Morningstar can help you find new investments (and filter out all the bogus information that exists on the internet).

However, 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 of course, it depends what you’re looking for. Brokerage accounts allow you to buy and sell stocks, bonds, ETFs and more (mutual funds are included in this list). In contrast, 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 a bit 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 know you’re better off with a discount broker.

Here are a couple of other things to consider:

  1. Fees. Fees aren’t the only consideration, but they should be a part of your decision-making process. 
  2. 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? 
  3. 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 one to five percent. It’s a good idea to get a sense of what those fees will entail.

Understanding fees

Mutual fund fees and expenses involve a sales charge (the load, described above), and to put it into context, it is the broker’s sales commission. All funds charge annual expenses, as well, 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 both options, as described briefly above. 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), and in this case, if you’re purchasing Class A shares, the front-end load will offer a lower sales load the more you purchase over.

On the other hand, 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 which combination of Class A, B or C will be the best option for you when it comes to load and no-load funds.

Final thoughts

It’s important to consider fees, share class, past performance, risk, etc. when considering which mutual fund is best for you.

However, don’t forget to read the prospectus of the mutual funds you’re considering. You’ll find everything you need to know, from financial statements, fund strategy and more. Investment objective and risk must be carefully considered as well.

Also, 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 a simple index fund that just tracks the S&P 500.

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

For more information about mutual funds and brokerage accounts, Benzinga’s got you covered.