Begin Your Investing Career Right With Some Mutual Fund Basics
Buying shares of a mutual fund is a simple way to get started in investing and build a sizable portfolio. You can select funds that mesh with your investment goals instead of having to analyze multiple stocks and bonds to find the right mix of securities suitable for your risk tolerance, expectations for investment growth, and other considerations. (See also: The Duel: ETFs vs. Mutual Funds)
Learn the basics to develop a foundation for making sound investing decisions.
Mutual Fund Defined
The U.S. Securities and Exchange Commission (SEC) provides definitions of a mutual fund, its portfolio, and its investors:
- Mutual fund: "a company that brings together money from many people and invests it in stocks, bonds, or other assets"
- Portfolio: "the combined holdings of stocks, bonds or other assets the fund owns"
- Investors: "own shares, which represent a part of these holdings"
Mutual Fund Types
There are many types of mutual funds and many ways to classify them. For example, you could categorize a fund by its management approach, market capitalization, or global emphasis. Note that some funds could be in more than one category. For example, a market-index fund based on the S&P 500 (such as Fidelity's Spartan 500 Index Fund or E*Trade's S&P 500 Index Fund), is passively managed, considered large-cap, and comprised of domestic stocks.
Here are a few classifications that are often used to describe mutual fund types:
Actively vs. Passively Managed
- Actively managed funds contain stocks that are handpicked according to criteria described in the prospectus.
- Passively managed funds include stocks in a market index, such as Standard & Poor's 500, NASDAQ 100, or Wilshire 5000.
- Large-cap funds contain mostly stocks of large, well-established companies with a market capitalization of more than $5 billion. (Market capitalization is the per share price of the stock multiplied by the number of outstanding shares.)
- Mid-cap funds consist primarily of stocks of mid-sized companies with a market capitalization ranging from $1 billion to $5 billion.
- Small-cap funds focus on stocks of businesses with a market capitalization of less than $1 billion.
Growth or Value
- Growth funds own stocks of companies experiencing relatively high growth in earnings and/or revenue.
- Value funds own stocks of companies with share prices that are currently undervalued in the marketplace.
- Blend funds contain a mixture of growth and value stocks.
- Sector funds invest in a specific market sector such as communications, utilities, or technology.
- Target-date funds allocate assets among stocks and bonds based on your anticipated retirement year. (The allocation is adjusted for lower risk as you near the retirement date.)
- Bond funds invest in U.S. Treasury, U.S. government agency, municipal, and/or corporate bonds.
- Socially responsible funds own stocks that have a social purpose, commit to certain environmental standards, or meet guidelines for being socially responsible.
- International funds invest in companies worldwide.
Mutual Fund Prices
Mutual fund prices are based on the value of fund holdings, figured at the end of each trading day. This number is called the net asset value (NAV). It is calculated by adding the value of the fund's stock, bond, cash, and other assets, subtracting liabilities, and dividing the total by the number of outstanding mutual fund shares.
Unlike stock prices, mutual fund prices do not fluctuate during the day and are not based on perceptions of market value but rather specific calculations. Shares are purchased by investors directly from mutual fund companies or third party resellers (such as online brokerage firms), rather than being traded among investors.
Mutual Fund Fees
There are many types of fees associated with mutual funds. Some are related to specific transactions; others reflect costs to manage and administer the fund. Typically, transaction-based fees are taken directly out of your invested funds whereas operating fees are calculated as a percentage of your shares, reducing the overall return on investment.
- Built-in sales commissions or sales loads that are charged as front-end loads when you purchase shares or back-end loads when you sell shares.
- Fees charged by your brokerage firm to buy or sell shares.
- Early redemption fees charged for selling shares soon after buying them, often within 90 days or less.
- Exchange fees for exchanging shares among funds in a fund family.
- Management fees paid to the investment advisor or fund manager for selecting securities that meet investment goals.
- Distribution or service fees (Rule 12b-1) to cover marketing costs.
- Other expenses, which include legal and administrative costs.
A prospectus provides information to investors about the mutual fund. According to the SEC, there are two kinds of prospectuses: statutory (the fine print) and summary (key facts).
The main things that you should consider when reviewing this information:
- Investment goals, objectives, and strategies.
- Fees and expenses as a percentage of holdings.
- Past performance to give you an understanding of recent and long-term performance compared to market indexes or benchmarks.
- Unusual risk factors, above and beyond typical investment risk.
- Portfolio turnover (how often stocks are bought and sold within the fund).
Read the prospectus before you invest. Most are available as a download on website pages associated with the mutual fund.
Note that there is risk involved in mutual fund investing. A return is not guaranteed, your money is not insured by the FDIC, and your investments may lose value. However, over the long term, owning shares in a mutual fund gives you the opportunity to earn returns typically much higher than interest from a CD or regular savings account.
Are you invested in mutual funds? How active are you? Are there terms or concepts that seem confusing or unclear?