How To Invest In Mutual Funds: A Beginner’s Guide

Millions of Americans use mutual funds to meet their investment and retirement goals but, like many financial products, mutual funds can be intimidating to understand at first. Below we outline what you need to know to use mutual funds as a key piece of your investment portfolio.

What is a mutual fund?

A mutual fund is a pool of money collected from investors that is then invested in securities such as stocks or bonds. Each share in the fund represents a proportional interest in the fund’s portfolio, so the more shares you own, the larger your interest in the fund.

If a fund holds 5% of its portfolio in Apple and 2% in Tesla, for example, your share of the fund will hold the same stocks in the same proportions.

There are thousands of mutual funds that allow you to invest in a variety of ways. You can find funds that invest in a diversified group of large companies, small companies, specific geographies or even certain sectors of the economy.

Active vs. passive mutual funds

One of the biggest distinctions between mutual funds is whether they pursue an active or passive investment strategy. The difference will determine how the fund invests and can ultimately have a big impact on the returns you earn as an investor.

Active mutual funds

Active funds are managed by professional investors with the goal of outperforming a market index, such as the S&P 500 index. For an active stock fund, the fund manager and a team of analysts will work to identify which stocks to own and in what quantities to achieve the best returns. Similarly, actively managed bond funds will attempt to beat bond indexes through superior management.

But actively managed funds often fail to match the performance of the index they’re trying to beat. On top of that, active funds usually come with steep fees — often around 1% of the fund’s assets — to pay for professional management. Your overall return is reduced by these costs.

Passive mutual funds

Passive mutual funds are set up to track the performance of a market index. They don’t require an expensive investment team to manage the portfolio because they aren’t trying to identify the best performers — they’re simply trying to match the index. This allows passive funds to charge very low fees (sometimes no fees at all), which leaves more of the return for the fund’s investors.

Passive funds may sound simple and even a little boring, but they consistently beat actively managed funds over long time periods. There will always be a few active funds that outperform their benchmark over short periods, but very few will do so consistently over the long term.

Types of mutual funds

There are many different mutual funds available, and it can be confusing to navigate them all. Here are some of the more popular types of funds.

How to invest in mutual funds

Investing in mutual funds can be broken down into three steps: how to pick a fund, how to buy shares in a fund and how to sell your shares.

How to choose a mutual fund

Choosing which fund to invest in can be intimidating — not least because there are so many options. The first thing to consider is whether a fund’s investment objectives are aligned with your financial goals.

• For beginning investors early in their careers, as well as people looking to build a simple retirement portfolio, investing in a low-cost S&P 500 index fund or a total stock market index fund, plus a total bond market fund, can be an easy way to build a diversified portfolio.
• For more experienced investors or people looking to invest in an actively managed fund, more research may be required. You’ll want to understand a fund’s overall approach and investing philosophy, and who the portfolio managers are making investment decisions on your behalf.

It’s crucial to consider the fees associated with purchasing shares in a fund. Remember that if two funds have the same investment performance, the one with the lower fees will leave investors better off.

How to buy mutual funds

Mutual funds can be purchased through online brokers or through the fund manager.

• Open a brokerage account: If you don’t already have one, you’ll need to open a brokerage account. You can then fund the account through an online transfer from your bank.
• Place a trade order: Once you’re ready to buy a mutual fund, you can enter the fund’s ticker symbol and the amount of money you’d like to invest. Most mutual funds have a minimum investment of a few thousand dollars.
• Reinvestment decision: When you place the order, you can decide if you want to have any dividends and capital gains reinvested into the fund, or distributed to your account. Choosing to reinvest can be a smart way to grow your portfolio over time.

There are some differences between the way mutual funds trade and the way a stock or ETF trades.

• Pricing: Mutual funds are priced at the end of each trading day based on their net asset value, or NAV. The NAV is calculated by adding up the value of the fund’s holdings, subtracting expenses and dividing by the number of shares outstanding. If you place an order after the market has closed, you’ll receive the next day’s closing NAV as your price.
• Minimum investment: Most mutual funds have a minimum investment of a few thousand dollars and you can choose to buy a certain dollar amount of a fund or a specific number of shares.

How to sell mutual funds

Mutual funds are sold similarly to the way they’re bought.

• Place a sell order: Using an online broker or the fund’s manager, you’ll place a sell order and will receive the next available NAV as your price. Since mutual funds don’t trade throughout the day like stocks or ETFs, you won’t know the price you’re selling at until the trade goes through.

Mutual funds sometimes have fees for selling the fund in a short period of time, known as early redemption fees, and are therefore not ideal for short-term trading. They’re best used as vehicles for long-term investing and are commonly held in retirement accounts or invested towards another long-term goal. You don’t need to monitor the fund’s performance daily or even weekly when you’re invested for the long run. Checking in quarterly or a couple of times each year should be enough to make sure the fund is still aligned with your objectives.

Who should invest in a mutual fund?

Mutual funds can be a good fit for many different investors:

• Beginners: New investors will benefit from the diversification of mutual funds as well as their low costs.
• Experienced investors: More experienced investors may find mutual funds focused on specific market niches they think will outperform, or identify talented active managers that can help them build long-term wealth.

You should consider investing in a mutual fund if the fund’s objective matches your investment needs. A fund that invests primarily in stocks isn’t going to be suitable if you think you’ll need the money one year from now, while investing solely in a bond fund likely won’t be the best option if you’re looking to meet long-term retirement goals in the distant future.

Watch out for mutual fund fees

Fees are a crucial consideration when investing in mutual funds, because costs add up over time. Just a 1% annual fee can significantly eat into your return over a decades-long investing life and throw a wrench into your retirement plans. While no one knows how well an investment might perform, everyone can be certain how much they’ll pay in fees.

Be sure to read a fund’s prospectus to understand what fees are charged. Often, there are many funds tracking the same index, so you can shop based on fees.

Funds can charge fees for a number of costs related to operating expenses. Management fees pay for the fund’s managers and investment advisor, while 12b-1 fees cover the costs of marketing and selling the fund. Other expenses include legal, accounting and a variety of administrative costs.

You’ll also come across load and no-load funds. Loads, or commissions, are charged by some funds and paid to brokers at the time of purchase or sale of shares in the fund. The commissions are typically calculated as a percentage of your overall investment. Funds that don’t charge this commission are known as no-load funds.

Mutual funds vs. ETFs: How they differ

Mutual funds and ETFs have a lot in common, but there are some key differences. Here are the main ones to consider.

• Minimum investments: Mutual funds typically come with an initial minimum investment of a few thousand dollars, while ETFs usually have no investment minimum.
• Trading: ETFs trade throughout the day on exchanges similar to the way that stocks trade, while mutual funds can only be bought and sold once a day at their closing NAV.
• Expense ratios: While it will depend on the type of fund you’re investing in, expense ratios tend to be lower for ETFs than for mutual funds. However, a mutual fund that tracks an index such as the S&P 500 will be cheaper than an ETF that tracks a very narrow industry or geography.
• Fees: ETFs typically have no fees beyond the fund’s expense ratios, while mutual funds sometimes have sales commissions that are charged during the purchase or sale of the fund. Be sure to understand all of the fund’s fees before investing.

Remember that a mutual fund or ETF isn’t itself the investment, but rather they’re the vehicles that allow you to invest in stocks, bonds or other securities. A fund can only be as good as the investments it holds, so be sure to understand how a mutual fund or ETF is invested before making a purchase.

FAQs

• How do mutual funds make you money?
  

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  Mutual funds make money by investing in securities on your behalf. The fund can only do as well as the underlying securities it holds. Income and appreciation are generally the two ways you can make money in securities.

  Income comes in the form of interest or dividend payments that are then passed on to you as a fund investor. Appreciation can be reflected in the net asset value per share of the fund or distributed to investors in the form of capital gains, minus any losses.

• How are mutual funds taxed?
  

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  Taxes might also be considered fees that eat into the ultimate return you earn as an investor. If you own mutual funds in a taxable account such as a brokerage account, you’ll owe capital gains tax if the fund has appreciated from where you bought it at the time of sale.

  One way around this is to own the funds in tax-advantaged accounts such as a traditional or Roth IRA. In those accounts, your funds will be allowed to grow tax-free even if you sell them. You’ll eventually pay taxes on withdrawals from a traditional IRA, but Roth IRA withdrawals are tax-free during retirement.

• How much money do I need to buy a mutual fund?
  

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  Investment minimums can vary from fund to fund, but most mutual funds come with a minimum investment of a few thousand dollars. If you don’t have that much to invest, you might consider an ETF, which can often be purchased for the cost of a single share or less, if you can buy fractional shares.

Bottom line

Mutual funds can be a great way to invest in a diversified portfolio of securities for a relatively small minimum investment. Be sure to read a fund’s prospectus before investing and understand the risks involved. Consider investing in index funds as a way to help keep your costs low so that more of the return ends up in your pocket.