What are mutual funds?
Build a diversified portfolio tailored to your financial goals with mutual funds that match your risk tolerance, asset allocation and timelines.
Mutual funds are investment vehicles that offer investors the opportunity to group their money together and buy stocks, bonds and other investments “mutually” to invest in a common objective, such as to generate current income or seek long-term growth.
As a mutual fund investor, you don’t directly own the stock in the companies the fund purchases. Instead, you share equally in the profits or losses of the fund’s total holdings — another reason they’re called “mutual funds.”
Other key characteristics of mutual funds:
- They’re run by professional money managers who decide which securities (stocks, bonds, etc.)-to buy and when to sell them, with the goal of giving you the best return on your investment.
- They typically have low minimum investments and are traded only once per day at the closing net asset value.
- You get exposure to all the investments in the fund and any income or losses they generate.
- They offer a wide variety of investment strategies and styles.
Understanding what mutual funds are and how they work
All mutual funds fall into two categories: actively or passively managed funds. These categories help determine the fund’s fees and performance.
Actively managed funds
These funds strive to beat the market. They’re overseen by portfolio managers who actively select the securities they think will outperform the market. Most mutual funds are actively managed.
| Pros | Cons |
|---|---|
| Opportunity to overperform — As active funds seek to beat the index, they offer you the potential to earn higher returns than the average. | Underperformance — Statistically speaking, most actively managed funds tend to do worse than the market index. |
| Defensive measures — Managers can minimize potential losses by avoiding certain securities, or by adding more conservative assets. | Active risk — Managers are choosing investments they think will bring high returns, which is great when they’re right, but has consequences when they’re wrong. |
| Tax management — While active funds trigger more capital gains distributions, your financial advisor can tailor tax strategies to offset these gains. | Expensive — Fees are higher due to frequent buying and selling, managerial salaries and research costs. |
Passively managed funds
These funds, known as index funds, are designed to mimic — rather than beat — a specific index (such as the S&P 500), replicating its holdings and, hopefully, performance.
| Pros | Cons |
|---|---|
| Low fees — Managerial oversight is much less expensive since managers aren’t choosing securities but rather, in most cases, mimicking what’s already in the index. | Lack of flexibility — Managers are usually restricted to a specific index or predetermined set of investments, no matter what happens in the market. |
| Transparency — Index funds are required to publish their holdings quarterly (and some publish more often). | Performance constraints — By definition, passive funds will rarely if ever beat the market. |
| Tax efficiency — An index fund’s typical “buy and hold” strategy doesn't usually generate large capital gains taxes. | No downside protection — In a down market, the fund’s return will be as bad as the index it tracks, or potentially worse. |
No matter how the mutual fund is managed, you typically earn money three ways:
- Dividends and interests — A fund may earn income from dividends on the stock or interest on the bonds it holds, which it then passes along to its shareholders, minus any expenses.
- Capital gains — If the fund sells securities that have increased in price, the fund has a capital gain. Most funds pass along these gains to investors at the end of the year, minus any capital losses.
- Fund share price increase — If the fund’s holdings increase in price but aren’t sold by the fund manager, you can sell your shares for a profit.
What fees and costs are associated with mutual funds?
Investing costs can be a key factor in your net return. To minimize these costs, it’s important to understand how mutual funds assess fees and expenses. These fall into three broad categories:
- Operating expense ratio (OER) — OERs cover the fund’s operating expenses and are annually factored into the total return you receive.
- Load — A one-time commission some fund companies charge whenever you buy or sell shares in certain load-based mutual funds.
- Transaction fee — A trading fee some brokerages may charge whenever you buy or sell mutual fund shares.
Why invest in mutual funds?
Mutual funds are popular for many reasons, including:
Diversification
Mutual funds give you an efficient way to diversity your portfolio without having to select individual stocks or bonds. They cover most major asset classes (groupings of similar investments such as stocks, bonds, and real estate) and sectors (specific segments of the economy such as consumer staples, energy, health care, etc.).
Professional management
Fund managers have extensive knowledge that helps them make investment decisions. A manager may adjust the portfolio mix based on changes in market conditions or a company’s performance to help the fund achieve its stated objective.
Convenience
You can buy or sell your fund shares on any business day, automatically reinvest the dividends and capital gains distributions, and exchange funds within a fund family without fees.
Transparency
Mutual funds are subject to industry regulation to ensure accountability and fairness. Additionally, you can see the underlying investments (stocks, bonds, cash, etc.) in each fund’s portfolio either online or via the fund’s prospectus.
Mutual funds and ETFs
Mutual funds can be also be used with exchange-traded funds (ETFs) to achieve additional diversification. For example, a mutual fund could fill a gap in a portfolio of ETFs. If you already own a number of large-cap domestic equity and international equity, as well as fixed-income ETFs, you can increase diversification by adding exposure to the mid- or small-cap asset classes via mutual funds. If the ETF family does not have a fund that meets your needs, consider adding a mid- or small-cap mutual fund instead.
Mutual funds also can provide exposure to certain asset classes with a more limited number of fund choices, such as emerging markets or international small cap.
If you already have a well-diversified portfolio of ETFs with different investment categories and asset classes, mutual funds may not be necessary. Before you consider supplementing your portfolio with other investment types such as mutual funds, see if you are eligible for lower fees — called breakpoints — if you invest a certain amount in a specific ETF family.
There is no universal figure for the amount of active or passive investments to include in a portfolio. Think about your desired level of involvement, sensitivity to fees, tax sensitivity and long-term expectations for the investments (e.g., outperform the market).
If the idea of lower expenses and the potential for greater tax efficiency appeals to you, a passively managed fund (especially an ETF) may be appropriate. If you prefer not to make individual investment decisions and want the chance to outperform the index, an actively managed fund may be appropriate.
Types of mutual funds
There are nearly 10,000 mutual funds available today, covering a broad range of industries, asset classes and market indexes. At Edward Jones, we try to simplify your choices by recommending funds that follow our investing principles of quality, diversification, and a long-term perspective.
That’s why we believe you should focus on these types of mutual funds:
- Balanced funds
- Equity or stock funds
- Bond funds
Balanced funds
A fund that combines stocks and bonds is called a balanced fund. The stock/bond mix is defined in the fund’s prospectus with a set minimum and maximum percentage for each.
If you're looking for income and modest growth, a balanced fund may be the right choice for you.
Equity or stock funds
An equity fund invests primarily in stocks. These funds are typically defined by the types of stocks they hold.
For example, you may have heard of small-cap, mid-cap and large-cap funds. These stock funds are categorized by the size — the market capitalization — of the companies they hold. The size of the companies a fund owns is related to how much risk it takes on because owning smaller, less established companies may be riskier.
At Edward Jones, instead of focusing on market capitalization, we think of stock funds in terms of their investment style. These styles include:
Growth and income funds — These funds typically pay a dividend, so investors can make money from taking or reinvesting the dividend income and from the growth of the fund itself.
Growth funds — These funds usually pay a small or no dividend, focusing instead on choosing stocks with growth potential.
Aggressive funds — These funds hold more aggressive stocks, such as those of smaller or younger companies. Some aggressive funds are considered specialty funds because they focus on only one sector, such as health care, commodities or real estate.
Stock funds can also be categorized by whether most of the holdings are domestic, international or both. An equity fund’s prospectus will detail the types of stocks it owns and in what percentages, as well as its objective.
Bond funds
Bond funds invest in bonds (municipal, corporate and government) and other investments considered fixed income, such as money market funds or even cash. The exact type of underlying investments in the fund will depend on its focus. Because the types of bonds inside a bond fund can vary, you should consider:
Duration — How sensitive the fund will be to interest rates, factoring in when interest payments are made as well as the final payment.
Credit quality of underlying investments — For example, government bonds are rated AAA, whereas high-yield or “junk” bonds are rated BB and below. The percentage mix of the quality of the investments will be defined in the prospectus.
Maturity — The average number of years until the par (or face) value of the underlying bond will be repaid.
How to start investing in mutual funds
Here are the steps you can take to invest in mutual funds:
- Define your investment goals. Determine why you want to invest in mutual funds. Are you aiming for growth, income or capital preservation? This will help you select the right type of fund.
- Choose the type of mutual fund. Based on your goals, select from types of mutual funds such as equity, bond or balanced funds. Equity funds have higher growth potential but can be riskier, while bond funds are generally more stable.
- Select a brokerage or investment platform. Decide where you want to purchase your mutual funds. You can invest through an online brokerage, directly from the mutual fund company or through your financial advisor.
- Open an investment account. Next, it’s time to set up your account. You’ll need to provide personal information and, in some cases, complete a risk profile assessment.
- Make your first investment. Now that you’ve opened an account, you can start investing. Decide on an initial amount and, if possible, set up automatic contributions. This enables consistent investing regardless of market conditions.
- Review and adjust regularly. Monitor your investment’s performance periodically, and adjust based on changes in goals, market conditions or risk tolerance.
Can I withdraw money from a mutual fund at any time?
Yes, you can generally withdraw money from a mutual fund as needed, but there are a few factors to keep in mind.
Mutual funds allow investors to redeem their shares at the fund’s current net asset value (NAV), which is recalculated at the end of each trading day. However, depending on the type of mutual fund and how long you’ve held it, there could be fees, taxes or other implications.
How we can help with mutual funds
Edward Jones recognized early on the value of mutual funds to individual investors. That’s why, for decades, our Investment Manager Research team has evaluated portfolio managers and fund performance using a well-defined process to provide a short list of quality recommendations.
Your Edward Jones financial advisor can use this team’s expertise to provide mutual fund choices that make the most sense to you. Find a financial advisor near you and get started today.
Important Information:
Federal Reserve resource for more information (pdf)
Mutual fund investing involves risk. Your principal and investment return in a mutual fund will fluctuate in value. Your investment, when redeemed, may be worth more or less than the original cost.
Edward Jones receives payments known as revenue sharing from certain mutual fund companies, 529 plan program managers and insurance companies (collectively referred to as “product partners”). For more information, see Revenue Sharing Disclosure (pdf).