Mutual Funds 101


Pen on top of chartsMutual funds are a popular investment choice for many investors. They offer simplicity, diversification and the flexibility to redeem shares on request. Mutual funds can help you build wealth and meet your short-term, medium-term and long-term financial goals.

What is a mutual fund?

A mutual fund is a “pool” of investments owned by many investors. When you put money into a mutual fund, the fund invests the money to produce profits and/or income for each investor’s fund account. The fund’s portfolio might be made up of a few dozen to hundreds of different securities.

To own a fund, you buy shares in it, and each share you own represents your portion of the entire pool of investments owned by the fund. Everyone invested in the fund shares in the gains and losses of fund investments.

How are mutual funds categorized?

Mutual funds are categorized in many different ways and any one fund can fall under multiple categories.

Asset class: a group of securities that have similar characteristics and values that tend to move in the same direction as other securities of the same class. The main asset classes are equities (stocks), fixed-income investments (such as bonds) and cash equivalents (including short‐term certificates of deposit and U.S. Treasury bills).

Diversification: a risk-management technique that involves spreading your savings around a large
enough quantity and variety of investments so that a significant loss on any one investment or segment of your portfolio won’t produce a big loss relative to your entire portfolio.

Index: a barometer of a specified type of investment and a benchmark against which investment performance is measured. A widely known index is the S&P 500, which tracks the stocks of the 500 largest U.S. stocks measured by their market capitalization (share price times number of shares in the market).

Evaluate funds by

What to consider

Asset Class

Funds are categorized by the primary asset class they invest in, such as:

  • Equities (stocks, including U.S. or international)
  • Fixed-income investments (short-term or long-term bonds)
  • Cash equivalents (short-term CDs or U.S. Treasury bills)
  • Natural resources, precious metals, commodities (corn, wheat or soybeans)
  • Real estate
  • Multi-asset: A combination of different asset classes
Investment Objective

A fund’s investment objective may be to achieve:

  • Capital appreciation (a rise in the value of assets; common for stock funds)
  • Current income (typically in the form of ongoing dividends; common for bond funds)
  • Preservation of capital (minimizing a loss in the value of assets)
  • A combination of objectives
Investment Technique

Some funds are identified by the technique or strategy they follow. For example:

  • Lifestyle funds invest in a mix of asset classes to match a specific investor risk profile. The fund’s investment mix may or may not shift over time.
  • Stock funds can focus on companies in a certain industry, like biotech or retail
  • Geographic region, such as U.S. or Europe
Management Style (Active or Passive)

Funds are also categorized by how they pick their investments.

  • An actively managed fund’s investment manager regularly makes decisions on which securities to buy, sell or hold.
  • A passively managed fund (also known as an index fund) minimizes trades, and management costs, by mimicking the makeup and performance of a specific market index like the S&P 500.

What are the benefits of a mutual fund?

Mutual funds offer the following advantages for investors.

  • May lower your risk — Each mutual fund share you buy gives you part ownership of a portfolio made up of multiple securities — this way you get instant diversification, which reduces the risk of having too many eggs in one basket.
  • Managed by a professional — Buying shares in an actively managed fund gives you access to a professionally managed, diversified portfolio that would be difficult to create on your own with a relatively small investment amount.
  • Low initial investment amount — Depending on the mutual fund, you might be able to start with a relatively small amount, and the fund might also allow your future contributions to be small. You can even set up automatic, ongoing investments through transfers of money from your bank account.
  • Easy to buy and sell your shares — You might be able to buy shares directly from the fund or through an investment broker or financial institution. Just write a check for whatever amount you wish to invest or arrange to buy shares electronically through your bank account. Funds also offer daily liquidity; to sell shares, contact the fund manager or ask your dealer or broker to sell them for you.

What are the risks of a mutual fund?

Like all investments, mutual funds can pose a degree of risk. Maybe the fund’s investments will perform poorly. Perhaps the financial markets where the fund invests will slump due to economic, political or other factors. Keep in mind, however, that funds come in a variety of risk and return profiles. For example, a fund that invests in stocks of “hot” start-up companies may pose more risk (and possibly provide a higher long-term return) than a fund that invests mostly in bonds, which offer more moderate risk and a moderate return.

How to choose a fund

Before deciding whether to invest in a certain mutual fund, consider your personal objectives, how much risk you’re comfortable with and your time horizon. Do as much research as you can, and use financial publications and websites to learn about specific funds. Many mutual fund company websites include information that helps you sort through their mutual funds using various criteria.

Every fund will have its own prospectus — a legal document that shows important details about the fund, including its investment objectives and technique and past performance. Review the prospectus of any fund you’re seriously considering buying. Find out about any commissions and other costs you may incur as an investor. Also, look up the fund’s expense ratio, which is calculated by dividing the fund’s annual expenses by its average net assets. Typically, a higher expense ratio lowers your return. However, keep in mind that lower expenses do not necessarily result in higher returns. You can find a fund’s prospectus on the mutual fund company’s website or call them directly for a copy.

Need help? Ask an advisor.

There are a multitude of mutual funds and other investments to choose from. If you don’t feel knowledgeable enough to choose investments confidently, consider hiring a professional financial or investment advisor for guidance. An advisor can help you create the right mix of investments based on your personal goals, your time horizon for achieving those goals, and your tolerance for risk.

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