If you’re an investor with $1,000, building a diversified portfolio of individual stocks is nearly impossible. Investing that same $1,000 in a mutual fund makes it easy.
“Instead of having to go out and purchase 30, 40, 50 individual stocks, this is one way, in one fell swoop, to get exposure in one vehicle,” said Andrew Briggs, wealth manager with Plaza Advisory Group.
Mutual funds, which have been around for 100 years, allow investors to pool together money safely and efficiently. While they may get overshadowed by exchange-traded funds (ETFs) these days, they’re still the main option for 401(k) and other workplace retirement accounts. Learn how to buy mutual funds and key information about these investment vehicles.
What are mutual funds?
Mutual funds are pooled investments, allowing a group of people to take advantage of professional managers who can pick securities to create diversified holdings. Mutual funds are regulated by the Securities and Exchange Commission under the Investment Company Act of 1940, which mandates fund issuers explain the risks of owning and buying mutual funds.
Active versus passive mutual funds
Mutual funds are either passively or actively managed. A passively managed fund follows an index, such as the S&P 500. Joshua Goldberg, senior wealth advisor at GYL Financial Synergies said the fund companies will mention what index the fund is tracking so you can understand the type of fund and have an expectation of how it will perform. An index fund’s returns should closely track the return of the index it follows — no more, no less.
An active fund is run by a portfolio manager who picks securities with a goal of beating a certain index, Goldberg said. Here, too, the fund issuing company should include information on the fund’s benchmark so an investor can compare the active manager’s skill against the chosen index.
Investment research firms such as Morningstar will also list the performance of funds on their websites, whether actively or passively managed, and show how the particular fund’s performance not only ranks compared to the benchmark but also against its peers.
Goldberg said that the annual cost to own an index fund is lower than an actively managed fund because index funds don’t have managers overseeing the holdings. The fees on an active fund also include the cost to pay the manager.
Types of mutual funds
Mutual funds can invest in different types of securities, said Goldberg. Here are some common fund types:
- Stock funds: These funds invest in the stocks of publicly traded companies. Stock funds may focus on the size of certain companies, such as large-cap stocks. They may favor certain styles, such as growth companies, whose businesses managers expect will expand in the future. Stock funds could also target certain industries, like technology, or may focus on strategies, such as dividend-paying stocks.
- Bond funds: These funds invest in fixed-income securities and debt instruments. The holdings can range from US Treasury bonds to corporate bonds, high-yield bonds (also known as junk bonds) or international bonds.
- Real estate investment trusts: REITs, as they are commonly known, invest in real estate companies. They can range from apartment buildings to hotels, warehouses, data centers or even cellphone tower properties and farmland.
- Commodity funds: Commodity funds usually invest in companies that are involved in natural-resource production, such as agriculture, energy or mining. They may also own commodity futures contracts as part of their holdings.
- International market funds: Managers of these funds focus on investing outside of the US. These funds may invest in developed international markets, such as in Europe or Japan, or may specialize in emerging markets, such as China or Latin America.
- Money market funds: These are often used by investors as alternatives to bank savings accounts. Managers invest in ultra-short-term investments that mature in days or weeks and may have slightly higher yields than high-yield bank savings accounts.
Many mutual funds are actively managed by portfolio managers who select individual holdings with the goal of beating a benchmark, although some mutual funds are passively managed and follow an index, such as the S&P 500 stock market index. Investors can select different types of mutual funds to create an investment strategy and take advantage of diverse holdings to spread out risk in their overall portfolios.
Unlike ETFs or stocks, mutual funds trade once a day and are priced at the net asset value of their holdings at the end of the day, after the markets close.
Who should invest in mutual funds?
Anyone who wants to have a diversified investment should consider investing in a mutual fund. These vehicles are appropriate for new or seasoned investors alike. Since mutual funds must pay taxable capital gains distributions when they generate realized, long-term investment gains on their holdings, mutual fund investors may want to own them in a tax-sheltered account, such as a 401(k) plan or an individual retirement account (IRA) to avoid paying taxes every year.
How do mutual funds make you money?
Mutual funds make you money by investing in securities, such as stocks and bonds, although they may also invest in other securities, including real estate investment trusts (REITs), commodities or international markets. The goal of investing in mutual funds is to stay invested over long periods to allow your investment gains to compound.
Mutual funds versus ETFs
Mutual funds and ETFs are similar in that they have diversified holdings and are listed on exchanges. Both have similar regulatory protections under the Investment Company Act of 1940.
There are a few differences between these investment vehicles, however. Mutual funds trade once a day, at the end of the day, but ETFs trade throughout regular market hours, like stocks. ETF holdings are generally transparent, so at any time you can see what securities the fund holds and how they are weighted in the fund. Mutual funds usually update their holdings monthly. ETFs often are cheaper to own than mutual funds as well, as they generally have lower expense ratios. ETFs can be purchased for the price of one share, whereas some mutual funds have minimum investment requirements.
Goldberg said that ETFs tend not to pay capital gains distributions, which also makes them more tax-efficient than mutual funds.
Steps to buying mutual funds
Buying mutual funds online is a straightforward process. The steps to buying mutual funds include:
- Research fund companies: Narrow down the type of investment strategy you want to use, and compare funds with similar strategies to decide which is right for you.
Look beyond the name of a fund and evaluate its holdings and its performance. You’ll find this information on the fund issuer’s website, the brokerage platforms you use to buy mutual funds or at research firms such as Morningstar. Most mutual funds update their holdings monthly, although they are only required to do so quarterly. Seeing holdings on a monthly or quarterly basis is a snapshot in time, but it allows you to view the biggest securities the fund owns and what percentage each stock, bond or other asset comprises the total fund makeup.
Key metrics to consider are how the fund performed versus its stated benchmark and versus its mutual fund peers over the short and long term, which will give you a sense of how it performs in different market cycles.
For actively managed funds, read the investment goals and purpose, review the lead portfolio manager’s process, look at their tenure to see how long they have been managing the assets and if the fund’s performance matches, Goldberg said. A good sign is if the portfolio manager invests their own money in the fund they manage. For index funds, the fund performance should closely match its benchmark, minus fees.
- Open and fund an investment account: Before you can buy mutual funds, you’ll need to have an investment account with available funds. If you have a workplace retirement plan, such as a 401(k), 403(b) or 457(b) plan, you likely already have the ability to invest in a selection of mutual funds. If not, you may choose to open a traditional or Roth IRA, where you can invest in mutual funds and other securities. A third option is to open a taxable brokerage account, although this type of account doesn’t provide the tax advantages of IRAs and other retirement plans.
Investigate different brokerages and their offerings, Goldberg said. Check for trading costs to buy or sell mutual funds and how easy it is to use the site. Many fund issuers allow you to buy mutual funds from their websites directly.
“Each brokerage will charge different fees for trading different types of investment vehicles, and they have access to different types of mutual funds. Make sure the broker is well capitalized and has a decent reputation,” Goldberg said.
- Place your orders and monitor positions: Once you’ve opened and funded an investment account, and you know which mutual funds you want to purchase, it’s time to put your money to work. Enter the name or ticker symbol of the funds into the account’s order entry ticket, select the number of shares you wish you purchase, along with the other required trade parameters, and confirm your order.
As noted, mutual funds only trade once per day, after the close of regular market hours. If you place your order during regular market hours, it should execute at the close of trading that day. If you place your order after the market closes, it should execute at the close of trading the following day. Ensure your order has been executed by checking its status on your brokerage account’s order history page.
Mutual fund fees and expenses
Mutual funds have various fees, and these costs cut into your return, Briggs said. Common fees include 12b-1 fees for advice, which are often baked into the fund’s expense ratio, and sales loads, which are commissions to brokers to sell the mutual fund. Some funds also have exit fees when you sell. No-load funds are fund companies that do not charge sales loads.
The advisors recommended investors seek no-load mutual funds and, if they are using a financial advisor, to make sure the advisor avoids load funds as well. Sales loads generally range from 4% to 8% on the initial purchase.
Mutual funds also have different share classes and will charge fees based on how much money a person can invest. The A share class for retail investors usually has the lowest investment minimums but often the highest upfront fees. Institutional share classes, often called I shares, have lower fees but much higher minimums. Financial advisors often have access to institutional share classes.
According to the Investment Company Institute, the average expense ratio for equity mutual funds was 0.44% in 2022, meaning for every $1,000 invested annually, an investor would pay $4.40. For bond mutual funds, the average expense ratio was 0.37%. Choosing index funds over active funds can help mutual fund investors save money. The average cost for an actively managed equity mutual fund was 0.66% in 2022, while the average annual fee for an index-based mutual fund was 0.05%.
Mutual fund taxation
If held in a qualified account, such as a 401(k) or IRA, mutual fund taxes aren’t a big issue. But if you hold mutual funds in a taxable account, it’s important to understand what taxes you may pay, Briggs said.
If a mutual fund’s value increases in price and a portfolio manager sells those winning holdings, it causes capital gains. Taxes on capital gains, along with dividends, are passed along to investors, usually near the year-end.
If a mutual fund has a capital gains distribution, all fund shareholders will have to pay that tax, even if they just bought the fund, because of how mutual funds are structured. Mutual funds are pooled investments, so new investors will also inherit the embedded cost basis of when the portfolio manager first bought those shares.
Briggs said mutual funds will post when they make capital distributions each year, which are paid to shareholders as of the record date. These distributions usually happen at the end of the year, and he suggested investors hold off purchasing a fund until after the record date passes to avoid unnecessary capital gains taxes.
Sometimes, fund managers need to sell securities to raise cash if they don’t have enough cash on hand to pay investors who sell their shares. This can become a problem during volatile market swings, such as in 2020 or 2022, when many investors sought to redeem shares.
During those times, portfolio managers may be forced to sell long-held holdings to raise liquidity, triggering a capital gain. It’s also why sometimes mutual fund investors receive capital gains tax bills even if the fund has lost money during the year, Briggs said.
“We don’t see it a lot, but folks may raise a question of ‘how can I have negative performance on the year and I’m still getting a taxable gain,’” he said.
Overall, Goldberg said investors need to think about how the mutual fund fits in their overall portfolio and maybe consider a similar type of ETF if the investment isn’t going to be a long-term holding, as mutual funds aren’t designed for trading.
“If you’re looking to invest in mutual funds, know that these aren’t short-term investment vehicles,” he said.
How to sell mutual funds
Selling mutual funds is straightforward. You can log into your brokerage account, or the account you have at the mutual fund company, and redeem shares. You can sell a few shares or your entire holding. The price you get is the net asset value (NAV) recorded at the end of the day, after the fund’s price settles.
Depending on the mutual fund share class, you may pay a deferred sales load charge, also referred to as a surrender charge, when you sell. Class B or class C shares may impose a sales charge, and that will lower your total return. Some mutual fund companies may impose a fee for redeeming shares too soon after the purchase date. The time frame for these early redemption fees can be anywhere from 30 days to one year. Companies slap on these fees to discourage short-term trading.
Frequently asked questions (FAQs)
A no-load mutual fund does not include a sales load. Sales loads can be anywhere from 4% to 8% and are paid on the initial investment.
Yes, mutual funds are a good vehicle for new investors because they allow you to own a diversified portfolio with a relatively small amount of money.
Yes. Mutual fund values fluctuate based on the performance of their holdings and market conditions.
Yes, but the amounts vary based on the fund type.
In an open-ended fund, a portfolio manager creates new shares each time an investor buys the mutual fund and removes shares when an investor sells it. At the end of each trading day, these funds trade at their NAV.
A closed-ended fund is created to hold a set number of shares. The funds are traded throughout the day on an exchange, and the fund’s price may trade at a premium or a discount to its NAV.