How To Invest In Mutual Funds
Investing in mutual funds requires decisions about whether to adopt a passive or active investment approach, the choice of a broker, understanding fees and sticking to an investment plan.
What are mutual funds?
A mutual fund is a company specialized in investing money in financial instruments such as stocks, bonds, and short-term debt. The company pools money from many investors to purchase and manage a diversified portfolio according to its prospectus, hence the term “mutual” in mutual funds. Investors don’t directly own a mutual fund’s stocks and bonds. They buy and own shares in the mutual fund, with each share representing part-ownership in the fund and the income it generates.
Index funds vs. mutual funds
Index funds are a subcategory of mutual funds. While different mutual funds have a diverse set of investment strategies, index funds solely invest in indices. Indices track the performance of a basket of shares or bonds. Their goal is to provide a simplified market overview over a specific market segment. The most common stock market indices are the S&P 500, the Nasdaq 100, and the Dow Jones Industrial Average.
Hence, index funds follow a passive investment strategy. Instead of hiring costly fund managers to make investments decisions, index funds simply replicate an index. This reduces costs and eliminates the risk of significantly underperforming the markets. The flip side of this is that index funds cannot outperform the market.
Read the guide: How To Invest In Index Funds
A basic distinction concerning mutual funds is their management approach. Mutual funds can either be actively managed or follow a passive approach. A fund’s fees and performance depend on whether a fund is actively or passively managed.
Actively managed mutual funds are operated by professional fund managers who attempt to earn additional profits by outperforming the market. Their tools are stock and industry picking, anticipating bull and bear markets, analyzing and foreseeing trends and timely portfolio reallocation to growth sectors. Due to their active portfolio management involving lots of research and analysis, actively managed mutual funds charge significantly higher management fees than passively managed funds and ETFs. Research has proven though, that most actively managed funds underperform passively managed funds and the markets, especially when taking their higher fees into calculation.
In many cases it is therefore more profitable to invest in passively managed mutual funds, which invest to align with a specific benchmark such as the S&P 500. By simply mirroring the benchmark, no market research and analysis is necessary, which significantly reduces fees for investors. Two popular types of passive funds are index funds and exchange-traded-funds (ETFs). While index funds (and mutual funds in general) usually only calculate one price per day after the daily markets close, ETFs are traded all day like stocks on exchanges.
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Pros & cons of mutual fund investing
Mutual funds are seen as a conservative investment which offers relatively high safety due to their diversifying investment approach. Nevertheless, mutual funds do not protect investors from short term market volatility and crashes.
- Capital gains and dividends Mutual funds are eligible instruments to accumulate wealth through capital gains and dividends. Money invested in mutual funds with a diversified strategy and a good track record for a long period of time have a high probability of increasing your capital and generating a solid return on your investments.
- Affordability Many mutual funds have low entry barriers with minimum investment requirements of several hundred dollars up to $5000. Some brokers even offer the purchase of fractions of funds, leading to even lower minimums, or no minimum at all.
- Simplicity After making the initial effort of finding a suitable mutual fund with a good track record and a fair fee structure, investors have a relatively small role to play. The fund manager or the benchmark index will do all the heavy lifting for them.
- Diversification Mutual funds are a great instrument to diversify your investments, as they include a multitude of companies, sometimes from different industries and even multiple countries. This allows for strong diversification, which reduces risk.
- Fees Management fees incur, regardless of a mutual fund’s performance. As fees are calculated in % of your invested capital and not on the generated profits, investors must pay them in good and bad years. However, fees are much lower with passively managed funds, which mitigates the impact for these types of funds.
- Lack of control Mutual funds only allow for investments into the whole fund. Also, the fund manager or the index determine the investments, leaving no option for an individual investor to influence these decisions. This is especially important with actively managed funds, where the fund manager has much ample scope within the limits of the fund’s prospectus.
How are Mutual Funds taxed?
In most jurisdictions, realized capital gains are taxable. That also means that capital gains are only taxable once the financial instruments have been sold. Depending on a mutual fund’s strategy, it trades in and out of securities often, or prefers to hold positions over a long period of time. This influences the number of taxable events it causes each year. For investors holding mutual funds long term, the trading strategy can therefore have a significant impact on their tax bill and the overall net performance.
Depending on the jurisdiction you are living in, in general, when starting to invest in mutual funds, it is advised to first max out tax-privileged accounts. Many countries encourage retirement planning through tax benefits. As most retirement accounts allow investments in mutual funds, taking advantage of the offered tax benefits for long-term investing and saving is a smart way to start investing. Additional funds can then be deposited in a personal brokerage account.
Types of mutual funds
Both, actively and passively managed funds follow a variety of investment strategies. These basic strategies differ from each other depending on the asset classes they invest in. The main types of mutual funds are:
- Equity (stock/securities) funds are typically the riskiest mutual funds, but also have the greatest potential profits. Stock markets are highly volatile, which can significantly affect the returns of equity funds. Equity funds are divided into further subcategories such as growth funds, income (dividend) funds and sector funds, which focus on different types of equities.
- Fixed income (bond) funds are less volatile and therefore considered less risky than equity bonds. There is a broad variety of different bonds available, rated by professional firms according to their default risk. When investing in fixed income funds you should research each fund individually to determine the quality of bonds it is investing in. Bond yields have decreased significantly over the last decade, making them less attractive investments compared to other asset classes.
- Balanced funds diversify their investments among different asset classes like stocks, bonds, and other financial instruments. That is why they are also called allocation funds or hybrid funds. Balanced funds can also be funds of funds, which invest in a group of other mutual funds.
- Money market funds offer relatively low risk with low expected returns. By law, money market funds can invest only in short-term, high-quality investments that are issued by corporations or governments.
How to invest in mutual funds
Step 1: Decide your strategy
Before making an investment, it is important to ask yourself the following questions, as they will help you to find a mutual fund fitting your personality and situation:
- What are your goals for investing?
- What is your timeframe? Is it short-term for a car or long-term for real-estate or retirement?
- How much do you want to invest each month?
- How much risk are you comfortable with?
For short-term goals, low volatility and low risk investments in money market and fixed-income funds are recommended. For long-term goals it is preferable to choose balanced and equity funds with higher risk, higher volatility but also higher expected returns in the long run.
Step 2: Decide the mutual funds to invest in
Most brokers provide research tools for mutual funds including detailed information about each fund. You can filter the mutual funds according to their types and find a short description about each fund’s primary investments, its goals, fees, and the past performance. Alternatively, investors can also use tools like the Mutual Fund Observer and Maxfunds when researching potential mutual funds.
Step 3: Decide where to buy
Mutual funds can be purchased through various outlets. Most investors opt to buy mutual funds through an online brokerage such as Fidelity, Robinhood and Schwabb. They have simple user interfaces, low fees and provide access to the most common financial instruments such as stocks, bonds, ETFs, and funds.
Step 4: Monitor your investment
Investing in mutual funds allows for a hands-off investment approach and daily monitoring is not necessary. Nevertheless, a quarterly portfolio check is advised to stay up to date with the latest market developments and to have a feel for your investment performance.
Depending on your investment goals, it can make sense to set up monthly deposits into your brokerage account, which then can be invested too. This approach is called dollar cost averaging. This forms a continuous and disciplined investing habit, which is especially important for retirement accounts.
Should one of your investments significantly underperform compared to the respective benchmark then a revision of that investment is recommended. The goal isn’t to chase the highest possible rewards by swapping in and out of mutual funds continually but to have competitive returns on your investment. Should an investment repetitively fail to generate such returns, then a reallocation of your funds can be beneficial to your portfolio
Investing in mutual funds is a simple and low-effort way to invest your money. It does neither require much knowledge about the financial markets nor the overall economy nor individual companies. As such mutual funds are well suited for investors wanting to participate in the overall long term economic growth without having to do lots of research on their own.