What Is a Mutual Fund?
A mutual fund is a type of investment in which investors’ money is pooled together to purchase stocks, bonds or other securities.
Quick take: Mutual funds are a great way for investors to build a diversified investment portfolio for a long-term goal, such as retirement. Instead of buying individual stocks and bonds to painstakingly build a diversified portfolio, an investor can gain exposure to hundreds or even thousands of companies with just one share of a mutual fund. Easy peasy. Cross “investing” off the to-do list.
Tell me more! If you know you should invest for the future — and you really should! — but you’re worried about your ability to build a diversified portfolio using individual stocks, then a mutual fund can be a great way to go. That said, nothing is ever quite as simple as we’d like, right? Here are three things you should know about mutual funds:
1. Mutual funds have a variety of investment goals. For example, there are broad-based funds such as “total stock market mutual funds” that invest in every publicly traded company. Other mutual funds focus on a smaller niche, such as mid-cap companies (i.e., companies that fall between large-cap and small-cap companies; market capitalization is calculated by multiplying total outstanding shares by the share price), or international companies. (Read more about how to invest for retirement.)
2. Most mutual funds have one of two types of structures: a mutual fund will either be an index mutual fund or an actively managed mutual fund.
- Index funds track an index. Basically, an index is a collection of securities grouped around an idea, such as “500 of the biggest publicly traded U.S. companies,” which is what the S&P 500 is. Index mutual funds aim to match the return of whatever index they’re tracking. They are not out to beat the market, but simply match a return. Because they are following an index, rather than actively buying and selling investments, index mutual funds tend to be much cheaper than actively managed mutual funds.
- Actively managed mutual funds employ fund managers to pick investments based on their knowledge and research. You will pay extra for this service, and those higher fees will eat into your investment portfolio without necessarily providing any type of sustained market-beating return.
3. Mutual funds charge fees that you need to watch for.
- Most mutual funds charge an expense ratio, which is charged as a percentage of your invested money. These days, expense ratios can be very low, such as, say, 0.03%. Some companies, such as Fidelity Investments, even offer some mutual funds with a 0% expense ratio. At the other end of the spectrum, some mutual funds charge expense ratios higher than 1% — over time, this ongoing fee can severely eat into your money, so be sure to shop around for a low expense ratio.
- Some mutual funds charge a commission or sales charge, called a “load.” To save money, look for no-load funds.
- Some brokers might charge transaction fees for buying and selling mutual funds. Look for “no transaction fee,” aka NTF, mutual funds.
Bottom line: Mutual funds are an easy way to build a diversified portfolio, but you have to find the right mutual funds for you. When in doubt, consider broad-based funds, such as total stock market or total bond market funds, and look to index funds for the lowest fees.
No joke... fees really do matter
Here’s a look at how investment fees really can mess you up. Let’s say you have $100,000 invested, earning 4% annually.
- After 20 years with a 0.25% expense ratio, you’d have $208,815
- After 20 years with a 0.5% expense ratio, you’d have $198,979
- After 20 years with a 1% expense ratio, you’d have $180,611
Senior writer Andrea Coombes explains mutual funds.
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