December 24, 2013
A mutual fund is a professionally managed investment pool made up of money from a large group of investors. The most common investments made by mutual funds are stocks, bonds and short-term debt. When you invest in a mutual fund, you are actually buying shares in its portfolio, giving you part ownership in the fund and the money (hopefully) that it generates.
Mutual funds fall into two basic categories:
- Actively Managed Funds -- Money managers choose the investments where your money will go based on your specific fund’s objectives.
- Index Funds -- Not actively managed, but seek to replicate the movements of a specific financial market, such as the S&P 500.
The Upside of Mutual Funds
Diversification: Mutual funds contain holdings in a broad range of investment vehicles, often representing thousands of securities. If some of these securities perform poorly, this diversity can minimize the negative impact on portfolio return.
Expert Management: Most investors do not have the time or investment knowledge to manage their own portfolios. This makes non-index mutual funds attractive because they are managed by professionals whose only job is to make sure the fund thrives while minimizing risk. In addition, indexed mutual funds, while not actively managed, are still professionally administered for your peace of mind.
Liquidity: Though not as liquid as stocks (which can be traded throughout the day), buy-and-sell orders for mutual funds are filled after market close. They also allow you to reinvest your dividends and interest in additional fund shares.
Convenience: When time is a consideration, mutual funds let someone work in the trenches so you do not have to micromanage your portfolio on a day-to-day basis.
Range of investment options: Mutual funds can match your own investment style: highly aggressive, risk-averse, middle-of-the-road or a bit of all three. You can also select from multiple asset classes, including stocks, bonds and money market funds. Additionally, within each major asset class there are further choices. For example, you can narrow your choice of a stock mutual fund to a specific market sector or region of the world. No matter what kind of investor you are, there is a fund out there to match your investment preferences and risk tolerances.
The Downside of Mutual Funds
You lose control of your portfolio. With mutual funds, the money managers –not you – will make the day-to-day investment decisions.
Capital gains tax. If your mutual fund holdings reside in a 401(k), IRA or other tax-deferred investment plan, you will have no immediate tax consequence when the fund distributes dividends. However, if your holdings reside in a taxable environment, you will owe taxes when the fund distributes dividends made by selling individual holdings in the fund, even if you personally have not sold any shares.
Fees and expenses. All mutual funds charge annual fees and expenses, which are based on your account’s value. Managed funds cost more to participate in than indexed funds. Moreover, management fees are assessed even if the fund managers’ investment decisions produce losses.
Cash drag. In order to maintain liquidity for purchases, mutual funds require available cash on hand. Unfortunately, investors wind up losing money because annual expenses are assessed on a fund’s assets, even if those funds have not been fully invested.
Most people without great investment skills who simply want to have a financial cushion at retirement choose mutual funds as the investment vehicle of choice. However, before putting your money into any investment, do your research and choose a fund that matches your own level of acceptable risk.