What Is a Mutual Fund?
A mutual fund is just an investment that holds stocks, bonds, and other securities or assets. I’ve seen a lot of people compare mutual funds to pizzas or soups or fruit baskets. I’m not going to be doing that today. Maybe I’m just not hungry.
A mutual fund is like any other investment. The main thing to note about mutual funds is that this single investment contains other investments within it.
A mutual fund combines money from many different investors and is led by a fund manager who is responsible for investing the money of investors to meet the goals of the fund.
Mutual funds are different from stocks and exchange-traded funds in that mutual funds do not trade during the course of the day. When you buy into a fund, the trade will actually take place after the markets close for the day.
Mutual funds are regulated by the Securities and Exchange Commission, whose main purpose is to protect investors and markets. The SEC published a 56-page document detailing mutual funds. I have included a link to this document in the references of this article.
I read this SEC document and I think it is a great source of information for both newer and more experienced investors.
The Advantages of Mutual Funds
Diversification
Diversification is the single biggest advantage of mutual funds. Mutual funds allow investors to spread out their money over a massive number of different companies.
These days, buying and selling stocks can be done pretty quickly and pretty easily. Even so, I think that you would find it almost impossible to buy, sell, and maintain a portfolio of thousands of stocks and bonds.
Mutual funds give you an easy way to spread your money across a large number of different investments.
Professional Management
Mutual funds are managed by professional investment advisors. Of course, not all advisors are the same. Some advisors will have more experience and may perform better than others. That being said, there is a lot of evidence that shows that passively managed index funds perform better than actively managed funds over time.
The hypothetical advantage of professional management is that you have an expert on your side whose goal is to help you make money.
Every mutual fund has a prospectus; a document that outlines the goals, risks, past performance, fees, and other details of the fund. Investment advisors are guided by the investment strategy laid out in the prospectus and seek to generate a return based upon the investment strategy of the fund.
So if you’re in a fund that invests only in large-cap stocks and that standard has been set in the prospectus, you don’t have to worry about the fund manager investing in anything like bonds or micro-cap stocks.
Low Cost to Get Started
Low starting cost is usually cited as an advantage of mutual funds but I think this is less of a factor these days. Many brokerages now offer fractional shares to investors. So rather than having to purchase an entire stock, you can buy just a portion of a stock.
Some stocks are incredibly expensive. Amazon’s stock price is currently trading for over $3,000 a share. If you think that is crazy; Class A shares of Berkshire Hathaway trade for over $350,000 a share.
Mutual funds offer a way for everyday people to begin investing in a broad range of companies for a relatively low cost.
Something to be mindful of is that mutual funds do often have minimum investment requirements.
Convenience
Mutual funds are just easy. You can buy into a fund in just a few minutes. Not all investments can be made so quickly. Like real estate for one.
Mutual funds are a set-it-and-forget-it approach to investing. You hand your money over to an investment advisor and they do the work for you.
Some investors prefer to manage their investments themselves but I think a lot of people like being able to hand this responsibility off to a professional to manage.
The Disadvantages of Mutual Funds
Taxes
They say there are two things in life that are certain. Death and taxes. When you sell stocks you have to pay taxes on any returns you made when you sold those stocks.
The same idea goes for mutual funds. But… and this is important… with mutual funds, managers may be buying and selling investments within the fund itself. Even though you may not have sold the fund, you are still responsible for any taxes that are triggered by the advisor’s selling of investments.
Fees
It is an amazing time we live in. Most online brokerages now allow you to trade stocks for free. Unfortunately, mutual funds are managed by professional advisors and that is a service you’ll still have to pay for.
Funds may have additional fees like expense ratios, transaction fees, and custodial fees.
Not all mutual funds have the same fee structures. Some may have a fee when you first buy into the fund and some funds have a fee when you sell out of the fund. Just make sure you are looking carefully at all of the expenses when you’re researching funds.
Types of Mutual Funds
The SEC breaks down mutual funds into a few different categories. The different types of funds offer a lot of variety in how you can invest.
Stock Funds
Stock or equity funds invest in stocks. If you need a refresher on stocks then take a look at the article here.
There are over 6,500 companies listed on the New York Stock Exchange. This gives you a lot of options so you can choose your investments based on your own risk tolerance and individual goals.
Stock funds are usually broken down by three main factors.
- The market capitalization. Which is just based on the size of the companies that make up the fund.
- The type of stock. Whether the stocks within the fund are growth, value, income, or blended stocks.
- The location of the stocks within the fund. Either domestic or international
There are a lot of different stock-based mutual funds. There are also a lot of ESG focused stock funds out there.
Just as an example, the Fidelity Select Environment and Alternative Energy Portfolio (FSLEX) is a stock fund focused on investing in alternative and renewable energy. There are a lot of other causes you can support through stock funds.
Bond Funds
You may be surprised to learn that bond funds invest in bonds. You may be noticing a little bit of a trend. These are also sometimes called fixed-income funds. I’m not going to go in-depth with bonds since I already created an article covering this topic. You can review that article right here.
Bond funds offer plenty of ESG investing opportunities.
Calvert offers a green bond fund (CGAFX) that focuses on environmentally friendly bonds. There are also some bond funds out there that are dedicated to creating positive social impact.
Balanced Funds
Balanced funds invest in both stocks and bonds. The goal of these funds is to maximize the benefits of each type of investment while attempting to minimize the downsides of these assets. Stocks traditionally yield better returns than bonds but bonds are less volatile than stocks.
The idea behind a fund made up of both stocks and bonds is that the fund balances out the pros and cons of each investment. Balanced funds are designed to generate a certain return based upon the risk tolerance of the investors within the fund.
Depending on your risk tolerance you may be in a fund that holds a higher percentage of stocks than bonds. Bonds are still included in the fund in order to reduce the overall volatility of the fund.
Money Market Funds
Money market mutual funds can only invest in short-term, low-risk investments like cash, certificates of deposits, and short-term debt.
Money market funds are highly regulated so they generally have the lowest risk compared to other mutual funds. The tradeoff to this is that investors also see the lowest rate of returns with these funds.
Many investors use money market funds as a short-term place to hold money. This could be for any number of reasons. Maybe you just sold off some stocks and are holding your money in a money market account until you find your next investment. Or maybe you’ve run into something in your personal life and you know you may have a need for some extra cash that you can access quickly. There are a lot of good uses for money market accounts.
Target Date Funds
Target date mutual funds are similar to balanced funds since both funds invest in stocks, bonds, and other investments.
Target date funds were created with a long-term perspective in mind and usually come in the form of retirement funds. A specific date is set for each of these funds and that date determines how the fund is rebalanced over time.
For example, the Vanguard Target Retirement 2065 Fund (VLXVX) is invested 90% in stocks and 10% in bonds.
By comparison, the Vanguard Target Retirement 2015 Fund (VTXVX) only invests 37% in stocks. These target date retirement funds are periodically rebalanced making this investment more conservative the closer you are to retirement.
Alternative Funds
Alternative funds invest in categories like real estate, currencies, or commodities like gold and crude oil. Investors often use these funds to diversify their portfolios. These funds can be complicated and are often more volatile than other investment options.
Smart-Beta Funds
Smart-beta funds can be a little confusing. A stock market index is the foundation of a smart-beta fund. These funds are primarily passive since they are based on an index.
But these funds also involve some active management. Fund managers might consider factors like risk or company fundamentals and buy and sell investments to meet certain goals laid out in the fund’s prospectus.
Active vs Passive Funds
Mutual funds can be managed either actively or passively. Passively managed funds seek to match a certain benchmark or index.
Let’s use the Standard and Poor 500 as an example. The S&P 500 index seeks to track the 500 biggest companies listed on U.S. stock exchanges. Some mutual funds have been created to match this index. So hypothetically any S&P index fund you buy into will be made up of 500 of the largest U.S. companies.
SPY is one of the most popular S&P 500 index funds but VFINX, and FXAIX are some other examples of index funds that track the S&P 500.
Remember that you are not investing directly in an index. You are investing in a fund that copies an index. I just wanted to make this point because I have seen some misinformation about mutual funds out there.
I’ve seen some YouTubers claim that you can only invest in index funds through exchange-traded funds or that mutual funds are always actively managed. That is not true.
Actively managed funds are run by fund managers who seek to outperform the market by buying and selling investments more frequently. But there is some debate about how well actively managed funds perform compared to passively managed funds.
I always try to ground myself in common sense. And if I didn’t know much about investing then I would think that active managers would have a huge advantage over passive funds because active managers can quickly get into and out of investments when they need to.
But because there are higher fees associated with actively managed funds, quite a lot of studies have found that actively managed funds actually underperform passive funds when the additional fees are taken into account.
I will say that some people take this line of thinking a little too far and have this belief that there’s no beating the market so it’s not worth trying. I’ll be honest, at one point I was one of those people.
But there are plenty of great investors out there that regularly beat the market. And I’m not just talking about people like Warren Buffet, Charlie Munger, Guy Spier, and Monish Pabrai. There are plenty of regular people that routinely beat the market by following the same strategies that the bigger investors use.
Financial Returns
Every mutual fund will have a prospectus that contains information about past financial performance. I know you’ve likely heard it a million times but past performance is not a guarantee of future performance. Even so, this is still information you should consider when comparing funds.
The financial performance will vary significantly depending on the fund you are looking at.
Mutual Fund Tips and Tricks
Compare Funds
There are a lot of different brokerages and most sell their own mutual funds. A mutual fund at one brokerage may have very different expenses than a similar fund at another brokerage. Do your research and compare a few different funds before you invest.
This is especially important for index funds. An S&P 500 index fund at one brokerage is going to be extremely similar to an S&P 500 index fund at another brokerage but there could still be a big difference between the fees of these two funds.
Take Advantage of Your Retirement Account
Fund managers buy and sell investments within a fund in order to keep the overall fund portfolio in line with the goals of the fund. This is a normal part of any mutual fund but this may happen more or less often depending on the type of fund you invest in.
Even passive index funds need to buy and sell investments in order to keep pace with whatever index the mutual fund is attempting to match.
Unfortunately, when an investment is sold within a fund it creates a taxable event for fund investors. There is a pretty simple solution for this. If you are investing using a retirement account then you avoid having to pay these taxes after each of these transactions.
Keep in mind that there is no escaping taxes but you can reduce your tax burden by using a retirement fund to invest in mutual funds.
Build Your Own Fund
Yes, even you can manage your own fund! Kind of. If there’s a fund you like, what you can do is copy that fund and just go out and buy all of the investments in that fund directly.
You can view each fund’s holdings so you can just pick up those investments in your own portfolio to match the fund you’re looking at.
This obviously becomes a lot more difficult when you’re trying to copy larger funds. A lot of funds hold hundreds or even thousands of different investments. It wouldn’t be very realistic for you to think you could manage that many investments yourself.
Some mutual funds are also made up of other funds. The “parent funds” usually have higher expenses than the funds that are contained within them. Many target-date funds are built this way.
If you see that a mutual fund you’re looking at contains other funds within it, then you might be better off investing within those smaller funds directly.
Mutual Funds and ESG Investing
There are over 10,000 mutual funds to choose from. With that many options, there is probably something for everyone. Mutual funds are also a great option for ESG investing.
Of course, you can always support individual companies directly but mutual funds are a great way to invest in a specific cause. Remember that all mutual funds have a prospectus that outlines the goals of each fund. Many ESG-focused mutual funds have goals related to specific missions or causes.
For example, the Pax Ellevate Global Women’s Leadership Fund is a mutual fund that invests in companies that rate the highest in advancing women through gender diverse boards, senior leadership teams, and other positive corporate policies.
There are funds that focus on minority empowerment, renewable energy, clean water, green bonds, sustainability, and a lot of other causes that investors might be interested in supporting.
Of course, only you can decide if mutual funds are the right investment for you but these can be a great tool in your investment portfolio.
Comment below and let me know if you’ve seen any other ESG funds that support any other unique or interesting goals and causes.
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