Diversifying your portfolio and reducing your risk exposure can be achieved by investing in mutual funds. However, all mutual funds are not the same. Some mutual funds follow a benchmark index, while others are managed actively by fund managers.
Mutual funds typically invest in a few securities, such as stocks, bonds, and short-term debt. However, the composition of each mutual fund can have a big impact on your risk exposure and investment returns.
Here’s what you need to know about mutual funds and how to decide which ones to add to your portfolio.
What are mutual funds?
Mutual funds are mutual funds that invest in a wide range of securities using funds contributed by a large number of investors.
By purchasing shares in a mutual fund, you become a “part owner” and receive a percentage of the fund’s profits.
Mutual funds invest in a range of assets, including stocks, bonds, and money market securities, or a mix of all three.
If you’re looking to invest, you can choose between stock funds, bond funds, money market funds, and target-date funds. Stock funds invest in stocks, bonds, and other types of stocks, and can focus on a particular sector, like tech or health care.
Bond funds invest in debt instruments from corporations and governments, while money market funds buy and hold better-than-market-day securities. Target-date funds look at their target date and adjust their portfolio composition over time.
So, if you want to retire by 2050, a fund that invests in that year will start with a lot of stocks and bonds, but as time goes on, it’ll become more conservative.
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Since mutual funds are managed by professionals, there’s no need for investors to do a lot of work. Plus, you can buy and sell shares whenever you want. Mutual funds usually have minimum investment limits, but some have no minimums at all.
Choosing between different types of mutual funds
There are two main types of mutual funds: passively managed funds and actively managed funds. Fees, investments, and returns vary depending on which type you choose.
Passively managed mutual funds
Passive mutual funds are also known as index funds because their goal is to replicate the performance of a reference index. For example, stock index funds may buy all or most of a company’s shares listed on an S&P 500 index or Russell 2000 index.
Passive funds don’t need a lot of management. Fund managers only make changes to the portfolio when the underlying index moves. Because of this, passive funds usually have lower fees.
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On the other hand, passive funds also don’t have as much flexibility to capitalize on short-term opportunities. For example, if the fund invests in a small number of securities in a benchmark index, a tracking error could lead to underperformance.
Actively managed mutual funds
The goal of actively managed mutual funds is to outperform the market by investing in stocks, bonds, or other securities that are selected by fund managers. Rather than buy and hold securities, fund managers make regular trades to seek short-term gains.
In many cases, this strategy works. According to the research firm Vanguard, active stock fund managers, on average, outperform their benchmark by about 37% and 36% respectively over the last 15 years, while active bond fund managers outperform by about the same amount.
However, actively managed mutual funds tend to charge higher fees than passive mutual funds.
How to pick the best mutual fund
With thousands of mutual funds on the market, it’s understandable to feel overwhelmed when trying to decide where to invest your money. While you’re researching and comparing options, here are a few things to keep in mind:
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Choose between actively or passively managed funds based on risk tolerance. Actively managed funds may be better for the sector or asset class outperformance, while index funds are better for matching benchmark performance without added risk.
Expense ratio and costs
According to ETF, active mutual funds charge an average expense ratio of 1.45%, while index funds charge 0.73%. Loads range from 1% to 2% of the investment, but most passive and some active funds don’t charge a load. In 2023, it makes little sense to choose a load fund over a no-load fund.
Rate of return
Check a fund’s performance over several years and compare it to a benchmark. If a fund has a clear advantage, it may be the better option.
Assets under management
Assets under management (AUM) measure a fund’s market value and indicate investor trust, with larger funds indicating higher levels of trust.
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Investing in sector-specific mutual funds can provide benefits but also expose you to risks. Understand the risks and consider diversifying to avoid them.
When choosing a mutual fund, consider your investment goals and time horizon. Equity investors need growth, current-income investors need income, and those nearing retirement age need low-risk securities. Stock mutual funds provide greater long-term returns than bonds or money market securities.
Turnover in a fund reflects how often the management team trades, with longer periods resulting in lower transaction fees and higher long-term capital gains, while shorter periods result in higher costs and lower capital gains.