Mutual funds are a popular way to invest in securities. Because mutual funds can offer diversification and professional management, they may offer certain advantages over purchasing individual stocks and bonds.
The holdings of the mutual fund are known as its underlying investments, and are determined by the mutual fund’s objectives as well as the professional managers. The performance of the underlying investments, minus fund fees and expenses, determine the fund’s investment return.
The following list comprises four of the major mutual fund categories:
- Equity funds invest in stocks
- Fixed Income funds invest in bonds
- Balanced funds invest in a combination of stocks and bonds
- Money market funds invest in short-term investments and are sometimes described as cash equivalents
Diversification
Mutual funds are designed to diversify investments by investing in more than one security (not all mutual funds are diversified in the same way or to the same extent). Investing in a diversified mutual fund strategy offers you the potential to enhance your overall return and help manage risk. By buying fund shares and effectively pooling your money with other investors, you can potentially spread your investment more widely than if you were purchasing individual securities on your own. You can also tap into foreign markets — including emerging markets — that are often difficult for individual investors to access.
A mutual fund’s diversification doesn’t guarantee you won’t lose money, but it can help reduce the day-to-day volatility in your investment’s value because you are investing in more than one security.
Professional management
One reason you might choose to invest in mutual funds is to benefit from the expertise of professional managers. A successful fund manager has the experience, the knowledge and the time to seek and track investments. Professional managers aim to outperform their benchmark by choosing investments they believe will be top-performing selections. While some believe that a professional money manager will generate returns above benchmark indexes, for those who do not, an index fund may be an alternative. An index fund buys many or all of the securities that make up the underlying market index, in an effort to replicate the index’s performance. Because index funds do not need to retain active professional managers, and because their holdings aren’t as frequently traded, they normally have lower operating costs than actively managed funds.
Lower trading costs
While it can be costly to purchase a diversified basket of individual securities on your own, you can generally receive the benefit of institutional buying power when you invest in mutual funds, thus potentially lowering the cost of building your portfolio.
Management fees
You pay a price for the advantages of investing in a mutual fund in the form of the fund’s annual expenses. These expenses cover items such as the portfolio manager’s salary and the fund’s administrative costs.
Taxes
As portfolio managers try to generate superior returns, they may sell securities and realize capital gains. If a fund has a net capital gain in a given year, this is distributed to shareholders in that tax year, who then have to pay taxes on the sum involved, unless they hold the fund in a retirement account where the taxes will be generally deferred. A mutual fund that owns dividend-paying or interest-bearing securities passes those cash flows to the fund’s investors, who may take dividend distributions when they are issued or may choose to reinvest the money in additional fund shares.