The Basics of Mutual Funds
Reading Time: 4 minutes
By Ian Bin
Are you aware of mutual funds? These open-end investment companies bring together money from numerous investors to invest in different securities, including bonds, stocks, and other assets.1 Each investor buys shares or portions of the fund, representing their part of the fund’s ownership. As the value of the investments in the fund goes up or down, the value of your shares change, too.1
Mutual funds can offer cost-effective diversification. Mutual funds can reduce investment risk by spreading your money across various companies and sectors.2 Concentrated mutual funds also exist and take a more focused approach to asset allocation.2 The benefit of doing so is that focusing on a handful of companies allows investment managers to concentrate their research efforts and invest strategically.
Mutual funds have different investment objectives. Some funds invest in a particular type of security, such as stocks or bonds. Some focus on a specific industry or region.1 You have a choice for the fund you want to invest in.
Professionals manage these funds by deciding what to buy or sell within the fund. Their job is to increase the fund’s value, and when the holdings appreciate in price, their fund’s share price also appreciates, to the benefit of you and other fund investors.3
Although the fund manager’s goal is to increase the fund’s value, just like anything in life, the fund can experience bumps along the way. The value of the mutual fund can go down if the investments in the fund do not perform well. Therefore, it is always important to consider your financial goals and risk tolerance before investing in a mutual fund.
What to look for in mutual funds
Investment objective:
Understanding the fund’s investment objective is essential because it will help you determine if it aligns with your financial goals for long-term growth, income, stability, or a combination.
Portfolio composition:
Sometimes, looking for diversity in the fund’s assets is advisable to balance risk and reward. However, this depends on your investment preferences.
Risk level:
Every mutual fund carries some level of risk. In general, higher potential returns involve more risk, which means you stand a greater chance of loss, so choose a fund that aligns with your risk tolerance.
Performance history:
Although past performance is not an indicator of future results, reviewing the volatility of a fund’s performance history can give you an idea of its future riskiness.
Fees (Main Categories):
Expense rate: This is a fee (indicated as a percentage) charged daily to an investment fund to cover a fund’s management fees and operating costs.4
Front-end sales load: The investor pays when they purchase fund shares.4
Back-end, or deferred, sales load: The investor pays when they redeem their shares.4
Different types of mutual funds
It is worth acknowledging that there are over 20,000 US mutual funds, which people may categorize differently. Morningstar groups them among over 100 different categories.
Cash
Money market funds are a type of mutual fund that invests in short-term, low-risk debt securities such as cash, cash-equivalent, and debt securities.5 They suit investors looking for a safe option with minimal risk.
Bond
These mutual funds primarily invest in government and corporate debt. Such debt issues are also known as fixed income investments because when initially issued, they promise to return a fixed amount on the initial investment.6 Although bond funds generally offer less growth potential than equity funds, investors often consider them safer.
Stock
Stock funds invest in stocks or shares of public companies. They aim to generate high returns by capturing the performance of the stocks of the companies they invest in.7 They are suitable for those looking for long-term growth.
Target-date
Target-date funds (TDFs) invest in a diversified mix of securities, including stocks, bonds, and other investments. Savers commonly invest in TDFs for retirement savings, with investors entering a fund based on their target retirement date.8 At inception, the asset mix of TDFs are at their riskiest, with allocations to stock as high as 98%. As they approach their target year, TDFs “de-risk.” That is, they reduce their allocation to stock, often to below 40%.
Index
Index funds track the performance of a specific market benchmark or index, such as the S&P 500 Index, and mimic that index’s performance. Instead of hand-selecting which stocks or bonds the fund will hold, the fund’s manager buys all (or a representative sample) of the stocks or bonds in the index it tracks.9
Taxation Concerns
If you hold a mutual fund in a taxable account, consider the fund’s turnover rate: High turnover rates may lead to more taxable gains, and capital gains must be reported every time the fund trades securities.10 Additionally, frequent trading can lead to higher trading fees, ultimately resulting in increased costs, which could reduce the net earnings of the fund.
Where to start
When deciding what mutual funds to invest in, the decision is based on your goals and needs. 3Nickels understands that. Whether saving for a dream vacation or considering retirement, it is all about connecting your life plans with the correct funds.
Once you have a clear picture of what you want, 3Nickels will recommend a mix of funds in distinct categories, chosen to match an appropriate level of riskiness for their goals.
When you are ready to take your research to the next step, the Investment module on the 3Nickels app will let you look at different investment account options that may work for you.
Resources
1 “Mutual Funds.” Mutual Funds | FINRA.Org, www.finra.org/investors/investing/investment-products/mutual-funds. Accessed 6 Dec. 2023.
2 “Diversified vs. Non-Diversified Investment Company.” Small Business – Chron.Com, Chron.com, 4 Mar. 2021, smallbusiness.chron.com/diversified-vs-nondiversified-investment-company-37629.html.
3 A Guide for Investors – Sec.Gov, www.sec.gov/investor/pubs/sec-guide-to-mutual-funds.pdf. Accessed 15 Dec. 2023.
4 “Mutual Fund Fees and Expenses.” Mutual Fund Fees and Expenses | Investor.Gov, www.investor.gov/introduction-investing/investing-basics/glossary/mutual-fund-fees-and-expenses. Accessed 15 Dec. 2023.
5 “A Guide to Money Market Funds.” Brex, www.brex.com/resources/what-is-money-market-fund#. Accessed 15 Dec. 2023.
6 Voigt, Kevin. “4 Types of Mutual Funds.” NerdWallet, www.nerdwallet.com/article/investing/types-of-mutual-funds. Accessed 15 Dec. 2023.
7 “What Are Equity or Stock Funds?” Vanguard, investor.vanguard.com/investor-resources-education/understanding-investment-types/what-are-equity-stock-funds. Accessed 15 Dec. 2023.
8 What Is a Target-Date Fund (TDF)?, 29 Nov. 2022, www.fidelity.com/learning-center/personal-finance/what-is-a-target-date-fund.
9 “What Is an Index Fund?” Vanguard, investor.vanguard.com/investor-resources-education/understanding-investment-types/what-is-an-index-fund. Accessed 15 Dec. 2023.
10 “Mutual Funds and Taxes.” Fidelity, www.fidelity.com/tax-information/tax-topics/mutual-funds. Accessed 15 Dec. 2023.
2 “Diversified vs. Non-Diversified Investment Company.” Small Business – Chron.Com, Chron.com, 4 Mar. 2021, smallbusiness.chron.com/diversified-vs-nondiversified-investment-company-37629.html.
3 A Guide for Investors – Sec.Gov, www.sec.gov/investor/pubs/sec-guide-to-mutual-funds.pdf. Accessed 15 Dec. 2023.
4 “Mutual Fund Fees and Expenses.” Mutual Fund Fees and Expenses | Investor.Gov, www.investor.gov/introduction-investing/investing-basics/glossary/mutual-fund-fees-and-expenses. Accessed 15 Dec. 2023.
5 “A Guide to Money Market Funds.” Brex, www.brex.com/resources/what-is-money-market-fund#. Accessed 15 Dec. 2023.
6 Voigt, Kevin. “4 Types of Mutual Funds.” NerdWallet, www.nerdwallet.com/article/investing/types-of-mutual-funds. Accessed 15 Dec. 2023.
7 “What Are Equity or Stock Funds?” Vanguard, investor.vanguard.com/investor-resources-education/understanding-investment-types/what-are-equity-stock-funds. Accessed 15 Dec. 2023.
8 What Is a Target-Date Fund (TDF)?, 29 Nov. 2022, www.fidelity.com/learning-center/personal-finance/what-is-a-target-date-fund.
9 “What Is an Index Fund?” Vanguard, investor.vanguard.com/investor-resources-education/understanding-investment-types/what-is-an-index-fund. Accessed 15 Dec. 2023.
10 “Mutual Funds and Taxes.” Fidelity, www.fidelity.com/tax-information/tax-topics/mutual-funds. Accessed 15 Dec. 2023.
