You’ve probably heard the term “mutual fund” mentioned on CNBC or thrown around by one of your more financially savvy friends at some point.
You know they have something to do with finance, but that’s about it.
In this intro to mutual funds, we’ll break it down for you.
So What the Heck Are Mutual Funds?
Mutual funds are basically big, professionally managed portfolios that you can buy shares of.
They pool together money from their initial investors (usually an investment firm) and shareholders, then use the money to buy all kinds of different securities.
Each share represents a commensurate slice of the whole portfolio, letting you buy a piece of a bunch of different securities instead of buying each security individually.
Each mutual fund is overseen by at least one fund manager who chooses what to buy and sell and when to do it—sort of like a financial advisor who doesn’t have to listen to you.
Why Do People Buy Mutual Funds?
Mutual funds are great for investors who want to diversify their portfolios but can’t or don’t want to buy each security individually.
Different funds also specialize in different securities and industries, so buying shares in a few funds can give you exposure to huge swaths of the market.
Not only do mutual funds give you exposure to a wide range of markets and industries, they let you buy into securities that you couldn’t afford otherwise.
For example, Warren Buffet’s Berkshire Hathaway (BRK.A) is currently sitting at over $400,000 per share.
It’s a bit out of the price range of the vast majority of individual investors.
But what if a bunch of individual investors pooled their money together and bought the stock?
Suddenly that $400,000+ price tag looks a lot less daunting.
Each investor would only own a portion of the stock—for example, pay in $4,000 for 1%, $40,000 for 10%, etc.—and would be entitled to an equivalent portion of any dividends or profits that the stock generated.
Mutual funds are a lot like this arrangement, just a lot bigger and a lot more diversified.
How Do I Make Money on Mutual Funds?
There are a few ways you can make money off of mutual funds.
Funds can be bought and sold like any other security at a price that reflects the net asset value (NAV) of the securities owned by the fund.
That means you can buy into a mutual fund, wait for its shares to become more valuable, and sell them for a profit.
The whole buy low/sell high thing works a lot like it does with stocks and ETFs, though there are a few differences.
Unlike stocks, mutual funds require a minimum investment of a specified dollar amount, and you can only trade them after the stock markets have closed.
The next way you can make money off of mutual funds comes in the form of interest and dividends.
Many mutual funds specialize in bonds, dividend stocks, and/or other securities that make regular payments.
Some funds hold onto the money they receive, but most pay it out to their shareholders as either a check or additional shares in the fund.
Finally, fund managers sometimes sell assets that have gone up in price since they first bought them.
The profit (capital gain) from those sales is also divvied up and distributed to the shareholders.
Neat. So What’s the Catch?
There’s no such thing as a free lunch, and there’s definitely no such thing as a free mutual fund.
The first downside of mutual funds is the yearly fees and/or commissions that they charge on top of the initial buy-in.
Passively managed funds may only charge you 0.2% of your overall investment each year, but actively managed funds may charge anywhere from 0.5% to 1.5% or even 2.5% on the high end.
Some funds even charge yearly percentages and additional fees and commissions.
The other big downside is the opacity of the average mutual fund.
You may have a hard time figuring out what any given mutual fund has in its portfolio, and that may be a dealbreaker for some investors.
That opacity also makes it tough to compare mutual funds. You’ll have to take a lot of funds at their word and put a lot of trust into the managers of the funds you do buy.
Mutual funds are interesting investment vehicles with both upsides and downsides.
You get to buy slices of diverse portfolios and gain exposure to way more securities than you could on your own, but you may not know exactly what’s in each fund’s portfolio.
There are multiple ways to make money with mutual funds, but you may have to pay fees that eat up your returns.
So now that you know the basics, let’s talk about how to find the right mutual funds for your investing strategy.