What is a Mutual Fund?

by | Oct 19, 2022 | Financial Planning

Wise investment decisions can help you grow your nest egg, but it can be difficult to determine which investments meet your needs. When you begin exploring your investment options, the sheer number of choices can be overwhelming. However, if you take the time to research the various types of investments, you can better understand the advice you receive from your financial advisor and feel more confident in your financial future.

Mutual funds are one common type of investment that your advisor might recommend. In 2021, 45.4% of U.S. households owned mutual funds, making them one of the most popular investment options. These funds provide many benefits, and it’s important to understand how they could function in your portfolio.

What are mutual funds?

Mutual funds are a collection of individual investments chosen by a professional fund manager on behalf of shareholders. They often contain stocks, bonds, or a combination of both. Investors who purchase shares of a mutual fund are then entitled to a share of its profits or losses. For example, a mutual fund could contain all the stocks in the S&P 500 or a selection of stocks in a particular sector.

Benefits of Mutual Funds

One of the main benefits of mutual funds is you can invest in them with minimal effort. With mutual funds, you can invest in companies of all sizes in every industry and many different countries without having to research, purchase, and maintain each individual position. Replicating this level of diversification with individual stocks and bonds would be extremely time consuming.

In addition to saving time, mutual funds allow you to achieve a level of diversification that you may not otherwise be able to accomplish without help or additional resources. For example, mutual funds can hold hundreds of individual securities and you may not have the time, inclination, or funds to maintain a portfolio of that size on your own.

Types of Mutual Funds

There are thousands of mutual funds, and it can be helpful to break them into categories to better understand them. Often, investors will differentiate between funds based on the type of securities they hold and the style of management. Some common types of mutual funds include:

Stock Mutual Funds

Stock mutual funds invest primarily in stocks. These funds are often further distinguished by industry, company size, location, and other similar criteria. For example, a “small-cap domestic stock fund” would invest in small companies headquartered in the United States. In your portfolio, stock mutual funds are intended to provide long-term growth and diversification.

Bond Mutual Funds

Bond mutual funds are comprised predominately of debt instruments. Bond funds can be further delineated by type of issuer, creditworthiness, duration, and similar factors. For instance, a “short-term government bond fund” would include a mixture of short-duration bonds issued by the U.S. government and government agencies. Bond mutual funds can provide a steady stream of income and the opportunity for capital appreciation to your portfolio.

Money Market Mutual Funds

Money market mutual funds are comprised of high-quality, extremely short-term debt instruments. These funds are typically considered safe investments. They seek to maintain a $1 per share price while providing a small amount of income. Because of their relatively low risk and stable price, these funds often serve as an alternative to holding cash in your portfolio.

Balanced Funds

Balanced funds typically include a mixture of stocks and bonds. These funds are sometimes referred to as “all-in-one” funds because some of them seek to create a diversified portfolio in a single fund. One example of this type of mutual fund is a Target Date Fund. These are a specific type of balanced fund designed for an investor with a particular time horizon. Target Date Funds are commonly used in employer sponsored retirement plans with the target date being the anticipated retirement date of the employee.

Index Mutual Funds

Index funds are mutual funds that contain all the investments in a particular index or benchmark. This type of fund is an example of a passively managed investment. This means trades are conducted when the index makes changes or rebalances, and no additional analysis or evaluation is performed to select securities.

For example, an S&P 500 index fund would contain all the stocks in the S&P 500 at any given time – in the same proportion that is maintained in the index. This is meant to ensure that the value of the fund moves at the same rate as the index. These funds often carry lower costs than actively managed funds because they typically require less analysis and fewer trades to maintain.

Actively Managed Mutual Funds

In an actively managed mutual fund, the portfolio manager selects securities with the intention of achieving a particular goal, such as outperforming a benchmark or generating a set amount of income. As the name suggests, active management generally requires more effort and trading than passive management.

Stock, bond, and balanced funds can all be actively managed. These investments often have higher management costs than their passively managed counterparts because they are designed to outperform them. This additional cost is due to the volume of trades and extensive analysis that is often required by managers to meet their goals. In turn, actively managed funds that significantly outperform their passive counterparts can provide additional benefits to your portfolio.

Mutual funds are often the most significant investment in many retirement plans. That’s why understanding the key facts about them can help you gain confidence in your future and help you have more informed discussions with your financial advisor.

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