What are mutual funds and why are they so popular?
If you’re a beginner investor and find yourself asking this question, this article is for you.
In this article, we’ll offer a mutual fund definition, explain why they’re getting so popular among investors, showcase advantages and disadvantages of investing in mutual funds, and more.
The Speed Read:
1. Mutual funds allow you to indirectly own a proportion of many assets with just one investment.
2. There are often fees associated with mutual fund investments. Keep this in mind before you choose your fund!
3. While you can’t choose the exact assets to invest in with a mutual fund, you can choose a fund that matches your values (so-called impact investing).
What are mutual funds?
Imagine you pooled your money with your colleagues every week to buy lottery tickets, sharing the winnings when your numbers came up.
Now imagine doing that same thing with strangers, in a far more financially reliable way than a game of chance.
Welcome to the world of mutual funds.
A mutual fund (often just called a fund) is a pool of investors’ money used to buy assets, such as stocks, bonds and gold. These assets are referred to as the fund holdings, or the fund’s portfolio.
Mutual funds are popular because they allow you to invest in a range of assets without having to put up huge amounts of money to do so. By adding your money to a larger investment pool, you gain the power of a much larger investor.
You won’t know the other people investing, as a mutual fund is a formal investment product rather than a private arrangement.
Unlike investing directly in stocks, bonds and the like, when you invest in a mutual fund, you don't own a proportion of the assets themselves. Instead, you own a unit of the fund — the fund is the entity that actually owns the assets.
How do mutual funds work?
So, how do mutual funds work and, most importantly, how do you make money by investing in them?
Despite not owning the assets directly, you make money in a mutual fund the same way you would if you did. With the fund’s shares, you’ll receive a proportion of the dividend payments, as well as a cut of any rise in value if the fund sells those shares. With bonds, you’ll receive a proportion of the coupon (or interest) rate, and the same rise in value when sold.
Because you don’t own the assets themselves, you won’t earn returns on an asset-by-asset basis. Instead, the overall fund’s performance will be assessed, and you’ll receive your return in the form of a payment based on the total performance of all of the assets of the portfolio.
Mutual fund costs
There are charges that come with investing in mutual funds. A key number to look for when researching the best fund for you is the expense ratio, which will tell you the impact of the fees on your likely return.
A measure of how much money is spent on the administration of a fund versus the money you make as an investor in that fund.
These fees cover a number of things.
There are the costs associated with maintaining the fund year to year. These include management costs (paid to the fund manager for their expertise), marketing costs and other administrative costs, such as legal and accounting expenses.
These expenses are shown as a percentage of the fund’s average assets, to produce the expense ratio.
In addition to these, there are also one-off costs charged to you as an investor.
The sales load goes to any broker you used in the transaction to buy into the fund. It can be as much as 8.5% of the total purchase, and can be charged when you initially buy into the fund or when you cash out. Funds that don't charge this are called no-load funds, while those that charge less than 3.5% are called low-load funds.
A redemption fee is a charge levied if you buy and sell your share of the fund within a short amount of time (this varies between funds from days to months). Not all funds charge this.
An account fee can be charged to maintain your account, paying for administrative costs, and often occurs if your account balance falls below a certain threshold.
The 6 types of mutual funds
There are different types of mutual funds, each offering a unique balance of risk versus reward.
Sector funds invest in stocks from a specific sector, such as the technology industry. That means they’re high risk, because you’ve effectively bet all of your money on that industry performing well.
Equity funds invest in a non-industry specific but carefully chosen selection of stocks. As stocks, they carry a high risk but can potentially earn you high rewards.
Index funds invest in all stocks in a particular index, such as the S&P 500. It mirrors what the index does, so your investment will rise and fall in line with that index. An index fund is less likely to see extreme highs and lows compared to an equity fund, so is lower risk with a lower reward.
Balanced funds invest in a combination of stocks and bonds. These balance high risk (stocks) and low risk (bonds) to produce a moderate risk product. The returns are therefore also likely to be moderate.
Fixed-income funds invest in bonds, providing a fixed return. Along with their lower return, these are lower risk.
Liquid funds invest in monetary instruments like Treasury Bills, cash equivalents such as gold, fixed deposits and debt securities that pay out in less than 90 days. They are designed to be easily bought and sold, providing a short term investment solution, and have the lower risk of all funds.
Actively vs passively managed funds
As well as the type of assets a fund invests in, there are two types of fund management that you should know about: active and passive.
An actively managed fund is run by a fund manager, who will monitor the market, and decide when and what to buy and sell on a daily basis. Because of this level of involvement and expertise, the fund will charge you a percentage of your investment as a fee. The size of that percentage varies between funds.
A passively managed fund follows a particular set of criteria when selecting stocks, and then automatically invests in those that meet those criteria. The most common example is the index fund, which allows you to invest in every stock that’s part of that index for your one investment amount.
A measure of how the stock market is performing, by taking a sample of stocks. By measuring what these stocks are doing, you can get a good understanding of the direction the market is moving. An index example is the Dow Jones, which measures stocks from the largest 30 companies listed on the New York Stock Exchange (NYSE). The Nasdaq and S&P 500 are the other two largest US indices. In investment terms, when people talk about “the market is up 50 points” they are often referring to one of these indices.
So what happens when you invest in a mutual fund long-term?
Here's an example based on the S&P 500 Index fund holder, who invested €200 a month for 40 years, never selling, and always reinvesting any dividends they received.
They made an investment of €96,000 between 1979 to 2019 — during which there were several financial downturns.
The eventual value of that investment in 2019 was an impressive €1.3 million, with a profit of €1,204,000.
In comparison, investing €200 a month in a savings account with an interest rate of 2% resulted in an eventual pot of just €143,000 with a profit of €47,000.
In contrast to an index-tracked fund, you may choose to be more aggressive in your investment, choosing a Sectorial or Equity fund. However, a fund that high in risk is not for everyone.
Only if the money you’re investing isn’t specifically allocated to something in your future you can’t live without — a house deposit, children’s educational costs, imminent retirement — is it worth exploring.
As well as not needing the money for essential future costs, the other thing you need as an aggressive investor is time. The longer you’re willing to leave your money in a fund (ideally more than 10 years), the more risk you can take. That’s because a longer time period will give you time to recover from any financial downturns, which are naturally more common with high risk investments.
Regardless of the fund type you choose, it’s important to fully understand all the charges you’ll be subject to before investing. The golden rule is that a fund with higher fees will need to perform better, delivering you higher returns, if you’re to come out on top.
In other words, in an ideal world active fund managers will make swift and smart decisions to offset any downturn in the market, justifying the expense of their services.
So then, are actively managed funds really worth it?
Research has shown that active funds generally outperform passive funds by 0.12%, which is then negated because of the 1% to 3% of fees that active funds charge investors.
However, this is based on a typical market — when things take a turn for the unexpected, it can literally pay dividends to have an advisor overseeing your investments.
It also assumes you’re motivated purely by profit, rather than any desire to be more selective in your investments.
There are mutual funds that you can choose to match your own values. With impact investing, for example, your managed fund brings with it the expertise of a financial professional who will look at the impact of a company, alongside its probable investment performance.
Impact investing only includes those companies working proactively to address a very particular problem or issue. The result is a much smaller list of potential investments, with many household names often notably absent.
An example of this is the Parnassus Endeavor Investor, which calls itself a ‘positive workplace fund’. It focuses on companies that treat staff well, as well as excluding firms that are involved in alcohol, gambling, tobacco, and fossil fuel.
This isn’t purely altruistic. Parnassus believes that the companies with good workplaces are more likely to be competitive in the market, and are subject to lower risk of things like workplace malpractice suits.
Another example is Cooler Future itself, a fund for climate impact investors. Cooler Future offers an impact-first investment methodology that aims to maximise financial returns while still prioritising Mother Earth. Our fund thus invests only in those companies that show a clear strategy for reducing carbon emissions, backed up with data rather than mere promises.
Again, these investments are not made on a purely altruistic basis. Aside from the ethical advantage, those companies already tackling emissions are ahead of the competition when it comes to inevitable future legislative changes regarding emissions reduction. They will also be unaffected by any fossil fuel pricing fluctuations, making them less vulnerable to sudden cost increases that can affect profits.
Advantages and disadvantages of mutual funds
There are several reasons that mutual funds have become so popular.
The first, and biggest, is the instant portfolio diversification mutual funds offer. By investing in a selection of assets, rather than just one, you’re more likely to be able to weather a financial downturn — if one asset suffers, it won’t affect your entire portfolio.
Pooling your money with other investors allows for large amounts of assets to be purchased on your behalf in bulk, which reduces the fees associated with these purchases. In contrast, if you were to purchase small amounts of stocks personally, you’d be charged much more.
Mutual funds also give you access to expertise, without you having to become the expert. Investing directly into things like stocks and bonds requires a lot of initial research and constant monitoring. This is all done for you when you invest in a mutual fund, whether it’s actively or passively managed.
When you make money on your investment and receive dividends, reinvestment is easy. By simply buying a larger proportion of the fund with the money you’ve made, you can significantly grow your investment over time.
All of this means that there’s a lot of demand for mutual funds, so they’re easy to buy and sell. This gives them ‘high liquidity’, which is seen as a real advantage in the investment world.
How quickly an investment asset can be sold and therefore converted into money quickly, without losing a substantial amount of value. Cash in your savings account would be considered high liquidity, while property would low liquidity, because it’s not easy to sell and can lose value when you do so.
But of course, mutual funds aren’t necessarily right for everyone.
While you can choose the type of fund you invest in, you can’t exclude individual stocks or decide to increase your investment in some but not others. This is all decided by the fund manager. So if you’re someone who wants complete control over their finances, it’s probably not the financial product for you.
Plus, unlike when you buy stocks directly, you don't have shareholder rights when you invest in a fund. That means you have no access to the annual meeting, or to vote on company decisions. Unfortunately, that means that you have no power to affect the future of the company. So if they choose to vote on, for instance, whether to switch from fossil fuel to renewable energy in their manufacturing plant, you have no say in that decision.
Finally, and perhaps the biggest reason that mutual funds are avoided by some investors, is the fees. Some funds are subject to a lot of charges, giving them a high expense ratio. This makes it harder to make significant returns, as a large proportion of the money made will go back to the fund manager.
Can you lose your money in a mutual fund?
You can’t go far in investment research without coming across some variation of the phrase “your investments can go down as well as up”.
This is just as true with a mutual fund as any other type of investment.
While diversification is an advantage and means that it’s unlikely all your investments will be hit to the same extent, there are other ways besides a lower stock price that you can lose money.
Fund managers can receive financial incentives to invest in some assets over others. This could be reflected in the investment decisions they make, which would not necessarily be to your advantage.
Bad fund management does happen. If the fund manager makes a series of bad investment decisions, this could mean losing some — or even all — of your money. It’s important to compare previous performance to other similar funds, and to the market as a whole, before you choose which one to invest in.
And going further than bad fund management is illegal fund management. If a fund manager is caught embezzling money, this would probably cause the other investors in the fund to try to sell their stake in it, flooding the market with supply with very little demand for buying. This, in turn, would drive down the value of your proportion of the fund, perhaps to almost zero.
In the US, the Securities Investor Protection Corporation (SIPC) guarantees funds up to $500,000. However, that isn’t based on the money you initially invested, but the value of the shares when you try to redeem them if a company goes bust. So if the price has plummeted to a fraction of what you originally paid, that’s how much you’ll be able to claim.
In Europe, coverage varies country by country. In Finland, for instance, a similar scheme exists that allows non-professional investors to claim the eventual (read: low) value of the shares, but only up to a total of €20,000.
Mutual funds are easy to invest in and instantly diversify your portfolio, which is why they’re so popular with all types of investors.
It’s like going to the supermarket and buying a trolley full of food without even getting out of your car — you might not like everything that’s been chosen, but at least you didn’t have to pay for parking, trawl up and down the aisles or queue at the checkout.
For some, that lack of personal choice means that it’s not the right investment for them. For others, that simplicity is enough to justify the fees that mutual funds often charge.
And if you’re just beginning your investment journey, finding a low or no-fee fund with a low minimum investment can be the perfect way of experimenting and understanding the world of investing.