When you invest in mutual funds, you put your money into a variety of securities that work together to help you pursue your investment goals. So, what are mutual funds, and how do they work in a portfolio?
What are mutual funds?
A mutual fund pools money from numerous investors and invests it in different securities. Think of it as a basket holding different types of investment assets.
A mutual fund can invest in such things as:
Individual stocks
Real estate
Precious metals
Commodities, such as oil or wheat
Other mutual funds (called a fund of funds)
Learn more: Invest in mutual funds commission-free (on eligible U.S. securities) with Ally Invest.
How do mutual funds work?
Mutual funds allow you to diversify your holdings, and they also give you the benefit of professional management. When you buy shares of a mutual fund through a brokerage, you become a shareholder in that fund and own a portion of each of the securities included in the fund.
Mutual funds allow you to diversify your holdings, and they also give you the benefit of professional management.
A fund manager decides which securities to buy and sell inside the fund based on its investment objective. They also oversee the fund's trading activities and use their expertise and knowledge to guide their decision-making.
Read more: Mutual funds vs. ETFs
So how do mutual funds work? Besides mutual funds increasing or decreasing in value based on their underlying investments, you can earn returns in a few different ways:
Dividends: A portion of a company's earnings that are paid to eligible stock owners on a per share basis, typically offered to investors on a regular cadence
Capital gains: Earned by selling your shares of a mutual fund for more than what you paid, or when a fund manager sells securities within the mutual fund for more than its initial purchase price. Read about the tax implications.
Types of mutual funds
Equity funds (aka stock funds): Primarily comprise stocks on major exchanges
Fixed-income funds (such as bond funds or money market funds): Invest in income-earning securities
Index funds: Designed to track a specific market index, such as the S&P 500
Balanced funds (aka hybrid funds): Invest in low- to medium-risk securities
Target-date funds: Invests in securities with the intent of making withdrawals at a certain time (at retirement age, for instance)
Specialty funds: Are focused on a certain industry or market
Fund of funds: As it sounds, invests in other mutual funds
How mutual funds are managed
Let's look at the two ways mutual funds are managed:
Actively managed funds are designed to try to “beat” the market, hopefully delivering above-average returns to fund investors.
Passively managed funds are designed to "meet" the market by mirroring the performance of a specific benchmark.
Read more: Mutual funds vs. index funds
Mutual fund expenses and fees
Mutual funds can charge ongoing fees and transaction fees. Ongoing fees are the different charges included in the fund's expense ratio (aka the annual cost of owning the fund). For instance, management fees, 12b-1 fees (which cover marketing and distribution costs) and operational fees. All fees are listed in the fund’s prospectus.
As a general rule, index funds and other passively managed mutual funds tend to have less expensive expense ratios than actively managed funds, but it's always important to compare them side by side to see how the costs add up.
Transaction fees include expenses like trading fees, fund share redemption fees and sales charges (aka loads). When it comes to these fees, mutual funds can be categorized by having:
Front-end sales load: Commission or sales charges when purchasing the mutual fund shares based on a percentage of the sales price
Deferred or back-end sales load: Flat fee or gradually decreasing fee you might pay when selling mutual fund shares
No-load funds: A no-load fund does not mean "no fees." Besides underlying fund expenses, a no-load fund can charge various transaction fees.
At Ally Invest, there are no transaction fees on mutual funds, but individual funds can have fees within them, so it’s important to account for the charges and expenses of any mutual fund you’re considering (which can be found in the fund’s prospectus).
Pros and cons of investing in mutual funds
Here are some of the benefits and drawbacks of mutual funds at a glance:
Benefits of mutual funds | Drawbacks of mutual funds |
|---|---|
Is relatively hands-off with a professional actively managing the fund | Will incur a management fee |
Offers the opportunity to reinvest dividends back into the fund | Is only as good as the professional who manages the fund, and that role can be subject to turnover |
Can be less risky when diversification is well managed within the fund | Requires some monitoring on the investor’s part to ensure expense ratios aren’t rising too high |
Investing in mutual funds
To start investing in mutual funds, you'll need to open an online investment account, which you can do with Ally Invest. Then, choose your fund with the following considerations:
Asset classes included (i.e. stocks, bonds, etc.)
Active or passive management
Fund performance and fund manager’s track record
Recurring and one-time fees
Finally, think about how a fund matches your objectives, risk tolerance and time horizon to see how it’ll fit into your portfolio's asset allocation.
