FinEdFriday: What Are Mutual Funds?

In this series, we are going to address some common financial questions from the ground up, using the simplest terminology, so that everyone can share an understanding of the basics. Whether you are just learning for the first time, or using these posts as a refresher, we hope we can set the record straight on some of the most commonly used terms in the finance industry.

In this financial education series, we have been discussing basic terms used in investing. We have covered stocks and bonds, both ways an investor (you) might possibly make a profit in joining arms with a company, or state, or government. An investment that is next in the natural progression of investing basics is the Mutual Fund. However, you cannot understand mutual funds without understanding the word “diversification.”

Diversification is a fancy sounding word thrown around quite often. However, it is  a simple term that can have many different contextual meanings, especially when used to describe investing. 

Let’s take stocks as an example. If you were to take some cash and invest into only one stock, this would be an “undiversified” investment. If instead, you spread your cash across multiple stocks, this would be a more diversified approach, because each stock may behave differently.

Diversification in investing - to spread your money out over multiple investments, thus reducing concentration risk.

But here’s the deal…achieving diversification takes time, money, and expertise. Not everyone has the time, money, or expertise to build a portfolio like that.  

Enter the Mutual Fund.

A mutual fund is a pool or bucket of stocks, bonds, etc. that you can purchase to achieve built-in diversification. A mutual fund is managed by a mutual fund company that builds the contents of this bucket to maximize the likelihood of achieving their goals (primarily, making you a profit). These buckets usually hold investments that are similar in nature (size of companies, strategy, etc.).

The Crayon Example for Investing

Hear me out. Imagine you were invited to a “blind” drawing competition (no, they don’t exist) where you do not know what you will be drawing until you arrive. You must only bring your drawing/coloring tool of choice. The judge calls out a certain subject to paint and off you go. Here are some people you might find at the competition:

“One crayon to rule them all”

This person brings one ocean blue crayon. They are betting everything on that one ocean blue crayon’s ability to properly color the subject the judge calls out. But what happens if the judge calls out something that is not ocean blue? This is like picking one stock, investing all of your available money in it, and hoping its value increases.

“One color wonder”

This person brings a box of every shade of blue. They are betting everything that the subject called is something that can be nuanced by different shades of blue (the ocean, a stream, the sky). This is like investing in one mutual fund, hoping that by spreading your risk over multiple investments in a bucket, you have better odds at holding one whose value increases.

“The 24 Twirler”

This competitor brings a 24 pack of crayons that covers most colors and even holds a few shades of each color. This is like building a portfolio made of multiple mutual funds, each holding a different subsector of global economies.

Yes, you might also find the “Grand Master 200,” who shows up with every shade Crayola makes. This is a very advanced, time consuming, and expensive way of investment management that is a conversation for another day. 

Back to mutual funds…

Where do you see mutual funds being used?

If you have an employer sponsored retirement account (401k, 403b, 457b), you probably are invested in a mutual fund, or a basket of mutual funds, like a Target Date Retirement Fund. Target date funds choose a date close to your perceived (retirement) date and create a group of mutual funds that become less risky as the “target date” approaches. 

The vast majority of individual investors use mutual funds to achieve diversification while keeping their fees and time-spent low. But be careful, you can easily fall trap to purchasing mutual funds that actually overlap each other in "exposure," or the type of companies in which they are invested. You end up paying twice for the same purpose.

Fees and Requirements

With the mutual fund company doing so much work behind the scenes to create and update the balance of stocks or bonds inside their mutual fund, they must be paid for their work. Your annual operating fee for holding a mutual fund is called an “Expense Ratio” and is expressed by number. A fund with an ER of 0.5 means that it costs .5% of your total investment balance each year. If you want to purchase $1,000 of this fund, it will cost you roughly $5 to hold throughout the year. These fees will be taken straight from your investment account, not invoiced to your bank account to be paid by cash or card. However, just because an expense ratio may be high doesn’t mean you shouldn’t buy it. Usually, you get what you pay for.

For some funds, you must pay an upfront charge, or "load", to purchase the fund in the beginning. However, there are some funds, called no-load funds, which can be purchased without that upfront fee. 

There also may be a minimum required amount in order to buy the fund. Some funds require you to purchase at least $2,500 of shares in the fund, while some may have no investment minimum at all.

Types of Mutual Funds

Stock (Equity) Mutual Funds

These are a basket of stocks belonging to a certain investment style (you will remember this from our post on Stocks). You can buy a mutual fund that holds Large Growth companies, or one that holds Small Value companies. 

Bond (Fixed-Income) Mutual Funds

These are a basket of bonds that seek to generate income in the fund, then pass it on to those that own shares. You might hear them referred to as “Bond Funds.”

International or Global Funds

This basket contains stocks or bonds that are not limited to domestic investments. International funds invest in companies that are outside of the US only. Global funds invest in companies that are both inside and outside of the US. 

Money Market Funds

These funds hold the least volatile of investments, like those backed by the US government. They do not have exceedingly high returns, but what you may lose in making money, you may gain in safety. 

Balanced Funds

Balanced Funds diversify their holdings across different types of investments according to a chosen strategy or according to a fund manager’s discretion. 

Index Funds

Index Funds are baskets of stocks that directly correspond to a major market index (think S&P 500 or the Dow Jones). These funds are popular because people may think there is no point in trying to outperform the overall stock market, so they are ok with their investments following the overall market regardless of what happens. These passive funds have lower expenses, because there isn’t much research or management happening behind the scenes. 

How do you make money with Mutual Funds?

Since mutual funds are managed by private mutual fund companies, you cannot buy them on a major exchange. Instead, you purchase them from the fund company or through a brokerage. There are three ways you can make money on a mutual fund.

First, when the fund manager sells an investment at a gain in the basket, you are passed a capital gain distribution, which can be taxable to you personally without you having sold your mutual fund.

Second, while holding the fund, you can be passed dividends or interest.

Third, when you personally sell your mutual fund, you profit the gain (growth) minus any fees and capital gains taxes (if applicable).

It is important to note that when you buy a mutual fund, you do not actually own the individual investments in that bucket. So you cannot control which shares to sell or which specific companies in which you want to be invested. 

In conclusion, mutual funds are a great way to achieve diversification without having to construct your own portfolio. However, you pay for this convenience, so it is important that you understand your options before selecting a mutual fund to purchase. 

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.