Should I Invest in Mutual Funds

Mutual funds are a widely favored investment option, offering a convenient way for individuals to access a diversified and professionally managed portfolio without the need to pick individual securities or actively rebalance their investments. These funds pool money from multiple investors to invest in a variety of assets, such as stocks, bonds or a combination of both, aligning with specific investment goals and risk levels. However, choosing the right mutual fund requires careful research, as thousands of options exist, each with unique objectives, fees and performance histories.

You may want to consider working with a financial advisor to guide you through the world of mutual fund investing if you’re not familiar.

What Is a Mutual Fund?

A mutual fund is a professionally managed investment portfolio composed of one or more asset classes. Think of them as baskets of stocks, bonds, commodities, real estate investments and more. Mutual fund managers generally determine their asset mix based on a particular investment objective. For instance, a mutual fund that aims for long-term growth may invest entirely in stocks and high-yield bonds.

But purchasing shares of a mutual fund is different from buying shares of individual stocks and bonds. When you buy shares of a mutual fund, your money is pooled with that of others who invest in the same fund. Therefore, your return is based on the fund’s performance and the proportion of its shares you hold.

Investors may also note that these pooled investments can offer more diversification than other financial investments like exchange-traded funds (ETFs). Since mutual funds invest in a variety of securities, the risk is spread across multiple assets, which aims to reduce the impact of any single security’s performance on the overall performance of the fund. However, mutual funds are subject to market volatility, which means that the fund’s value can drop during economic downturns or financial crises.

It’s also important to know that mutual funds trade once a day. Their share prices are based on their net asset value (NAV) and computed when markets close each day. The NAV equals the total value of portfolio assets (minus any liabilities) divided by the number of outstanding shares. However, you can’t always purchase just one mutual fund share. Most mutual fund companies require minimum investments that typically stretch from $1,000 to $5,000. But the market contains several different kinds of mutual funds.

Types of Mutual Funds

It’s important to note that the market currently houses more than 7,000 mutual funds, each with its own asset allocation, objective and investment strategy. So where do you start? Here are some common types of mutual funds and how they work:

Stock funds: These funds invest in shares of different companies. Some stock funds focus on investing in companies of a particular market capitalization. This is the total dollar value of a company’s outstanding shares. Large-cap, for example, defines companies with more than $10 billion in market capitalization. Generally, these are well-established firms. Investing in small-cap companies, on the other hand, may involve more risk.
Bond funds: These funds focus on fixed-income securities and pay interest to their shareholders on a regular basis. These funds may hold different types of debt instruments such as government, municipal or corporate bonds. The bond fund typically distributes interest payments monthly based on the underlying bonds in the mutual fund. So the income can change across different payment periods.
Balanced funds: These funds invest in a mix of stocks, bonds or other securities. Managers typically keep a fixed asset allocation based on the investment strategy of the fund. This can range from conservative to aggressive depending on the fund’s objective.

Pros and Cons of Mutual Fund Investments

When you’re considering an investment in mutual funds, it’s important to analyze the advantages and disadvantages that these investments could potentially bring to your portfolio. Here are the things you should consider before deciding whether mutual funds are right for you:

Pros of Investing in Mutual Funds

Dividend potential: You can receive dividends from the fund, which you can use to invest back into the same fund. This can help your investment value grow more rapidly.
Diversification: Mutual funds use diversification to invest in a number of different assets, which lowers your potential risk.
Easy access: Mutual funds are easy to understand and access.
Professional oversight: Mutual funds typically have a professional portfolio manager that oversees the investments of the fund.

Cons of Investing in Mutual Funds

Taxes: The taxes can bite you when the mutual fund decides to provide distributions based on their investment choices and you have no control over it. You’ll have to pay capital gains when it happens.
Slow trading: The trade execution time is slower than with other investments.
High expense ratios: Expense ratios can quickly get out of hand with some mutual funds. Keep an eye out for any funds that have a higher than normal (greater than 1.50%) expense ratio, and be wary of investing, as it can get expensive.
Poor management: There’s always the chance the fund is or becomes poorly managed, resulting in unnecessary trading, or in selling losing trades before the quarter ends in an attempt to fix the books.

How Do Mutual Fund Fees Work?

An investor reviews if he should invest in mutual funds.

Large fees can take a major hit on mutual fund returns. In fact, one of the downsides of investing in mutual funds is that they can have complex fee structures. We’ll break it down step-by-step but oftentimes, the extent of fees involved with investing in mutual funds depends on the fund’s management strategy.

1. Expense Ratios

First, each mutual fund charges an annual expense ratio to cover overall operating and management expenses for the fund. Expense ratios usually range from 0.5% to 1.25%. And they’re generally calculated as a percentage of income that the fund generates. Thus, your account would face its proportional share, reducing your overall assets.

In addition, some mutual fund expense ratios include 12b-1 fees to cover marketing and promotional costs. Under the law, this particular component can’t exceed 1%.

The amount that comes out of your account to cover the expense ratio is not explicitly detailed in your statements. But you can get a good glimpse of what you’re paying indirectly for fund expenses if you follow some steps. Multiply the expense ratio by the average balance invested in a 12-month period. Mutual funds may also charge load fees when you buy or redeem shares.

2. Load Fees

These fees are separate from the fund’s expense ratio. Load fees basically cover commissions paid to brokers and others involved in mutual fund transactions. These can span from 4% to 8% of your investment. Some mutual funds charge front-end loads, which they deduct from your initial investment when you purchase shares.

Other funds charge back-end loads when you sell your shares within a defined time span after you purchase them. Also known as deferred sales charges, these fees generally decrease the longer you hold onto your shares until the fee disappears. For instance, the back-end load may start at 6% if you redeem your shares within a year after purchase. And it can go away after you hold on to those mutual fund shares for six years.

Active vs. Passive Mutual Funds

An actively managed mutual fund essentially tries to beat the market. The fund manager will likely utilize a wealth of research and analysis theories to build a mutual fund with specific securities expected to make substantial returns. It may undergo several transactions in the process. Of course, all this takes money. So active funds tend to charge large expense ratios and loads due to the complex management activity.

Passively managed funds, however, tend to track an index of different securities such as the S&P 500. This consists of the 500 U.S. companies with the biggest market capitalization. In other words, the fund aims to mimic the overall return of the S&P 500 by investing in securities that already exist within the index. So it tries to copy the market rather than beat it. As you can see, this strategy strips away much of the careful picking that’s involved with active management. As a result, passively managed funds generally charge lower fees than their active counterparts.

While beating the market certainly sounds more lucrative than simply mirroring it, several studies indicate that actively managed funds rarely accomplish their overall goals. However, actively managed funds may be able to better hedge against risk because of their tendency to buy and sell securities when deemed necessary.

Finding the Best Mutual Funds

Some firms like Morningstar conduct extensive research on mutual funds. They can provide crucial data on a fund’s asset allocation and investment strategy, as well as manager bios. Such firms will also rate mutual funds according to multiple factors, including performance.

You can also find a lot of this information laid out in the fund prospectus. This document delineates key information about a mutual fund such as its fees, expenses, asset allocation and objectives. While researching potential mutual funds to invest in, good indicators may include the following:

A management team that has run the mutual fund for a long time
Successful long-term performance record (but keep in mind this is no guaranteed indicator of future performance)
Low fees compared to similar funds

Interestingly, a Morningstar study suggests that low fees may be the best predictor of mutual fund performance.

Should I Invest in Mutual Funds?

When it comes to determining whether a mutual fund is right for you, your financial situation and your investment goals, there are several things you’ll want to consider. You can also consult with a financial advisor before making a decision. Before choosing a mutual fund, take the following into account:

Your Investment Goals: Whether you’re looking for growth, income or capital preservation, know what your goals are. Different mutual funds focus on various strategies, such as equity funds for growth, bond funds for income or balanced funds for a mix of both.
Risk Tolerance: Mutual funds vary in risk levels. Equity funds, particularly those focused on smaller companies or emerging markets, tend to have higher volatility compared to bond or money market funds.
Expense Ratios and Fees: Mutual funds come with fees, which can include expense ratios, management fees and sales charges (loads). Lower-fee funds tend to outperform higher-fee ones over the long term, as fees can significantly impact returns.
Performance History: While past performance doesn’t guarantee future results, it’s still worth examining a fund’s long-term track record to assess its consistency over time. Look for performance over at least 5-10 years, but don’t rely solely on short-term trends.
Fund Manager and Strategy: Consider the experience and reputation of the fund manager. Active funds rely on the manager’s expertise to beat the market, so researching their track record and investment approach is important. Passive funds, like index funds, track a specific market index and usually have lower fees.
Minimum Investment Requirements: Many mutual funds have minimum initial investment amounts, which can range from a few hundred to several thousand dollars. Make sure the fund’s minimum fits within your budget.
Tax Efficiency: If you’re investing in a taxable account, consider the tax implications of the mutual fund. Some funds are more tax-efficient than others, distributing fewer capital gains, while others may generate higher tax liabilities.
Liquidity and Redemption Policies: Most mutual funds offer liquidity, allowing you to redeem your shares easily, but some may have restrictions or redemption fees for early withdrawals. Ensure the fund’s liquidity meets your needs, especially if you may need access to your funds quickly.
Dividend and Distribution Policies: Some mutual funds pay out dividends or distribute income regularly, which can be an important source of cash flow for income-focused investors. Others may reinvest earnings within the fund. Know how the fund handles distributions and how that fits with your income needs.

Bottom Line

An advisor and client review the pros and cons of investing in mutual funds.

Investing in mutual funds offers the advantage of professional management, eliminating the need to pick individual securities. Fund managers curate portfolios with specific growth objectives, but investors must still research their options. With a wide range of funds—stock, bond or balanced—it’s crucial to assess fees, asset allocation, objectives and the fund managers’ track records before investing.

Tips on Mutual Fund Investing

Because of the complexity of mutual funds, it can be a good idea to seek the guidance of a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Mutual fund fees can take huge chunks off your returns, which is why you should research investing costs with laser precision. But one good place to start might be with index funds. These passively managed funds generally charge lower fees than actively managed ones.