If you sit down with a financial advisor to chat about passive investments, they’re likely going to recommend that you invest in mutual funds. Mutual funds are generally recognized as a safe way to invest. They’re a true “set it and forget it” type of investment, popular with new investors and those with low risk tolerance. If you don’t have a lot of capital to leverage on your own and want to mitigate risk, a mutual fund is right for you.
Despite the relatively passive nature of mutual funds, it’s still important to know how they work. You might contribute to them every month and forget about them, but they’re still an investment vehicle. The more you know about how they work, the clearer your expectations about them can be. Here’s a peek behind the curtain of mutual funds and what to expect when you invest in them.
What is a Mutual Fund?
A mutual fund is aptly named because it pools investments from many investors. In leveraging funds from many, mutual funds offer purchasing power above and beyond any one single investor. This allows the fund to open and maintain larger positions, which generate greater returns. Those returns get distributed to every investor with a position in the fund by weighted contribution. There are three distinct ways to capitalize on a mutual fund investment:
- Dividends: Most mutual funds hold strong dividend-paying stocks. They either pay these dividends out to mutual fund shareholders or reinvest them. In either case, shareholders benefit from dividend returns.
- Appreciation: As the price per share increases, shareholder wealth grows. This is net asset value (NAV). It’s the same as holding any appreciable security. As the value goes up, it’s worth more depending on your position.
- Capital gains: Occasionally, fund managers will sell off a position in the mutual fund to reap the profits. After exiting, the sale from those profits gets distributed among shareholders. Most funds choose to do this annually.
The other aspect of a mutual fund that’s appealing for many passive investors is that it’s managed. Investors hold shares in the fund, but fund managers oversee the allocations within the fund itself. This is a further hedge against volatility and a safeguard for investors.
Types of Mutual Funds
There are both active and passive mutual funds. Active funds have managers that regularly oversee the performance of the fund, and investors can expect to beat the market. Passive funds typically pace the market and rely on automated rebalancing. The former comes with higher fees; the latter doesn’t usually incur any real fees.
After deciding on active or passive management, consider the nature of the assets in the fund. Here, you’ve got a few options:
- Equity Funds: These are mutual funds largely rooted in stocks.
- Bond Funds: These mutual funds are defensive, focusing on bonds.
- Balanced Funds: Expect a mixture of stocks and bonds in these funds.
- Money Markets: Funds heavy in cash and other short-term investments.
There are also more nuanced mutual funds, such as price or sector funds. From an asset standpoint, however, it’s best to decide whether you prefer to invest in debt securities, equity securities or a mixture of both.
The Benefits of Mutual Funds
Mutual funds are the epitome of passive investing. There’s no need to pick and choose individual securities. Moreover, the fund acts as a hedge against volatility thanks to diversified holdings. Managers oversee the stability and profitability of the fund. All you need to do as an investor is contribute regularly to raise your stake and maximize your return on investment.
There’s inherent simplicity, affordability and security in mutual funds. Moreover, they’re liquid—you can easily buy or sell, depending on your situation. Most investors continue to contribute to a mutual fund over time because they’re historically safe investment vehicles. This isn’t to say that mutual funds can’t lose value—it’s just that they’re not known to, aside from broad market downturn.
Drawbacks of Mutual Fund Investing
The only real downside of mutual funds is that outperforming funds come with a management fee, which can eat into your returns. Some historically well-to-do funds have active management fees as high as 3%! While passive funds have much lower fees, you’re still paying for someone to pace the market (or slightly outperform).
The other small drawback is that mutual funds are slow and steady investments. You’re not going to see massive returns in the short-term. Expect to invest for decades to see strong returns from a mutual fund.
Factors to Consider Before Investing
Before you dip your toes into a mutual fund, be aware of some of the biggest factors that will impact your investment. Here’s what to consider:
- Expenses and fees associated with active or passive fund management;
- Closed vs. open-ended funds, which dictates how many participants there are;
- Load vs. no-load funds, which dictate fees when entering or exiting the fund.
Above all, look at the historical performance of the fund and the fees associated with it. A well-performing fund with higher fees might outperform the market. Other times, a moderate fund with low-to-no fees is a headache-free investment option.
How to Make Mutual Funds Work For You
Are mutual funds going to spike and give you massive returns like a growth stock? No, but they’re not designed to. These are slow and steady investments that mitigate risk so you can invest passively. You don’t need to be an expert to invest in mutual funds. Instead, all you need is patience. These funds will follow the market and, managed properly, outpace it to generate returns. Over a long enough time horizon, these returns might just make up the bulk of your retirement fund!
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If you’re someone who’s risk-averse or doesn’t have time to constantly rebalance and evaluate a portfolio, consider mutual funds. They’re accessible, affordable and reliable. Whether you choose an active fund or default to a passive one, you can rest assured that your investment is working for you—even when you’re not keeping a close eye on it.