The Basics of Mutual Funds
What They Are and How They Can Make You Money
Mutual funds are perhaps the easiest and least stressful way to invest in the market. In fact, more new money has been introduced into funds during the past few years than at any time in history. Before you jump into the pool and start throwing your money at mutual funds, you should know exactly what they are and how they work.
As part of our Complete Beginner's Guide to Investing in Mutual Funds special, this article can give you the foundation you need to start understanding mutual fund investing.
What is a mutual fund?
Put simply; a mutual fund is a pool of money provided by individual investors, companies, and other organizations. A fund manager is hired to invest the cash the investors have contributed, and the fund manager's goal depends on the type of fund; a fixed-income fund manager, for example, would strive to provide the highest yield at the lowest risk. A long-term growth manager, on the other hand, should attempt to beat the Dow Jones Industrial Average or the S&P 500 in a fiscal year (very few funds actually achieve this; to find out why, read Index Funds - The Dumb Money Almost Always Wins).
Closed vs. Open-Ended Funds, Load vs. No-Load
Mutual funds are divided along four lines: closed-end and open-ended funds; the latter is subdivided into load and no load.
- Closed-End Funds
This type of fund has a set number of shares issued to the public through an initial public offering. These shares trade on the open market; this, combined with the fact that a closed-end fund does not redeem or issue new shares like a normal mutual fund, subjects the fund shares to the laws of supply and demand. As a result, shares of closed-end funds normally trade at a discount to net asset value.
- Open-End Funds
A majority of mutual funds are open-ended. In a basic sense, this means that the fund does not have a set number of shares. Instead, the fund will issue new shares to an investor based upon the current net asset value and redeem the shares when the investor decides to sell.
Open-end funds always reflect the net asset value of the fund's underlying investments because shares are created and destroyed as necessary.
- Load vs. No Load
A load, in mutual fund speak, is a sales commission. If a fund charges a load, the investor will pay the sales commission on top of the net asset value of the fund’s shares. No-load funds tend to generate higher returns for investors due to the lower expenses associated with ownership.
What are the benefits of investing in a mutual fund?
Mutual funds are actively managed by a professional money manager who constantly monitors the stocks and bonds in the fund's portfolio. Because this is his or her primary occupation, they can devote considerably more time to selecting investments than an individual investor. It provides the peace of mind that comes with informed investing without the stress of analyzing financial statements or calculating financial ratios.
How do I select a fund that's right for me?
Every fund has a particular investing strategy, style or purpose; some, for instance, invest only in blue-chip companies. Others invest in start-up businesses or specific sectors. Finding a mutual fund that fits your investment criteria and style is absolutely vital; if you don't know anything about biotechnology, you have no business investing in a biotech fund. You must know and understand your investment.
After you’ve settled on a type of fund, turn to Morningstar or Standard & Poor's (S&P). Both of these companies issue fund rankings based on past record.
You must take these rankings with a grain of salt. Past success is no indication of the future, especially if the fund manager has recently changed.
How do I begin investing in a fund?
If you already have a brokerage account, you can purchase mutual fund shares as you would a share of stock. If you don't, you can visit the fund's web page or call them and request information and an application. Most funds have a minimum initial investment, which can vary from $25 - $100,000+ with most in the $1,000 - $5,000 range (the minimum initial investment may be substantially lowered or waived altogether if the investment is for a retirement account such as a 401k, traditional IRA or Roth IRA, and/or the investor agrees to automatic, reoccurring deductions from a checking or savings account to invest in the fund).
The Importance of Dollar-Cost Averaging
The dollar-cost averaging strategy is just as applicable to mutual funds as it is to common stock. Establishing such a plan can substantially reduce your long-term market risk and result in a higher net worth over a period of ten years or more.
For more information, see the mutual fund section.