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What Is a Mutual Fund – Definition, Types, Pros & Cons

By Kalen Smith

mutual fundsMany investors want to diversify their holdings in order to limit their exposure to risk. However, most individual investors cannot afford the fees and commissions necessary to take large positions in a number of individual securities. Fortunately, they can take advantage of mutual funds.

There are a number of benefits to mutual funds, though it is crucial to examine the downsides, as well as your own needs, goals, and risk comfort, to determine whether mutual fund investment is right for you.

Definition of Mutual Funds

Mutual funds are investment vehicles that pool money from many different investors to increase their buying power and diversify their holdings. This allows investors to add a substantial number of securities to their portfolio for a much lower price than purchasing each security individually.

There are two types of mutual funds:

  1. Actively Managed Funds. With actively managed funds, professional money managers handpick investments according to the particular mutual fund’s objectives. These objectives vary widely, but could be investing overseas in small start-ups, focusing on a particular industry (such as oil), or diversifying between large-cap stocks and bonds.
  2. Index Funds. Index funds, on the other hand, are not actively managed, as they simply seek to replicate holdings in an index like the S&P 500.

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Advantages of Mutual Funds

  1. Diversification. Mutual funds spread their holdings across a number of different investment vehicles, which reduces the effect any single security or class of securities will have on the overall portfolio. Because mutual funds can contain hundreds or thousands of securities, investors aren’t likely to be fazed if one of the securities doesn’t do well.
  2. Expert Management. Many investors lack the financial know-how to manage their own portfolio. However, non-index mutual funds are managed by professionals who dedicate their careers to helping investors receive the best risk-return trade-off according to their objectives.
  3. Liquidity. Mutual funds, unlike some of the individual investments they may hold, can be traded daily. Though not as liquid as stocks, which can be traded intraday, buy and sell orders are filled after market close.
  4. Convenience. If you were investing on your own, you would ideally spend time researching securities. You’d also have to purchase a huge range of securities to acquire holdings comparable to most mutual funds. Then, you’d have to monitor all those securities. Choosing a mutual fund is ideal for people who don’t have the time to micromanage their portfolios.
  5. Reinvestment of Income. Another benefit of mutual funds is that they allow you to reinvest your dividends and interest in additional fund shares. In effect, this allows you to take advantage of the opportunity to grow your portfolio without paying regular transaction fees for purchasing additional mutual fund shares.
  6. Range of Investment Options and Objectives. There are funds for the highly aggressive investor, the risk averse, and the middle-of-the-road investor – for example, emerging markets funds, investment-grade bond funds, and balanced funds, respectively. There are also life cycle funds to ramp down risk as you near retirement. There are funds with a buy-and-hold philosophy, and others that are in and out of holdings almost daily. No matter your investing style, there’s bound to be a perfect fund to match it.
  7. Affordability. For as little as $50 per month, you can own shares in Google (NASDAQ: GOOG), Berkshire Hathaway (NYSE: BRK.A), and a host of other expensive securities via mutual funds. At the time of this writing, a share of Berkshire Hathaway costs over $119,000 a share.

Disadvantages of Mutual Funds

Although mutual funds can be beneficial in many ways, they are not for everyone.

  1. No Control Over Portfolio. If you invest in a fund, you give up all control of your portfolio to the mutual fund money managers who run it.
  2. Capital Gains. Anytime you sell stock, you’re taxed on your gains. However, in a mutual fund, you’re taxed when the fund distributes gains it made from selling individual holdings – even if you haven’t sold your shares. If the fund has high turnover, or sells holdings often, capital gains distributions could be an annual event. That is, unless you’re investing via a Roth IRA, traditional IRA, or employer-sponsored retirement plan like the 401k.
  3. Fees and Expenses. Some mutual funds may assess a sales charge on all purchases, also known as a “load” – this is what it costs to get into the fund. Plus, all mutual funds charge annual expenses, which are conveniently expressed as an annual expense ratio – this is basically the cost of doing business. The expense ratio is expressed as a percentage, and is what you pay annually as a portion of your account value. The average for managed funds is around 1.5%. Alternatively, index funds charge much lower expenses (0.25% on average) because they are not actively managed. Since the expense ratio will eat directly into gains on an annual basis, closely compare expense ratios for different funds you’re considering.
  4. Over-diversification. Although there are many benefits of diversification, there are pitfalls of being over-diversified. Think of it like a sliding scale: The more securities you hold, the less likely you are to feel their individual returns on your overall portfolio. What this means is that though risk will be reduced, so too will the potential for gains. This may be an understood trade-off with diversification, but too much diversification can negate the reason you want market exposure in the first place.
  5. Cash Drag. Mutual funds need to maintain assets in cash to satisfy investor redemptions and to maintain liquidity for purchases. However, investors still pay to have funds sitting in cash because annual expenses are assessed on all fund assets, regardless of whether they’re invested or not. According to a study by William O’Reilly, CFA and Michael Preisano, CFA, maintaining this liquidity costs investors 0.83% of their portfolio value on an annual basis.

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Are Mutual Funds Right for You?

Considering that there are more mutual funds on the market than there are individual stocks, the chances of finding one right for you are high. That said, mutual funds are most appropriate for people who don’t have the time or inclination to be heavily involved in managing an investment portfolio, and don’t mind paying an annual expense ratio to have a professional do it for them. They’re also ideal for people who simply can’t afford the level of diversification that most funds offer.

Still, if you seek diversification, but not necessarily professional management, index funds with their low expense ratios may be a good fit.

Final Word

To delve into the world of mutual fund investing requires you to first analyze your own situation, specifically, your needs and goals. Determine what you’re investing for and your comfort with risk to assess what types of funds to look at.

For example, if you’re choosing funds for your retirement account and have many decades until you reach retirement, a more aggressive mutual fund with low expenses would be ideal. Plus, you aren’t liable for capital gains tax on investments in qualified retirement accounts, so you could consider funds with high turnover that annually distribute capital gains.

On the other hand, if you’re saving to purchase a home within the next decade, you may prefer a fund that doesn’t often distribute capital gains and isn’t as aggressive as your retirement holdings.

To start searching for and comparing mutual funds based on risk, performance, expenses, and more, try the free fund screener at Morningstar.com.

(photo credit: Rambleon, Shutterstock)

Kalen Smith
Kalen Smith has written for a variety of financial and business sites. He is a weekly contributor for Young Entrepreneur and has worked as a guest blogger on behalf of Consumer Media Network. He holds an MBA in finance from Clark University in Worcester, MA.

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  • http://www.carinsurancecomparison.com/ Tyler S.

    As far as disadvantages, I would say the biggest one to look our for is the different fees you could be paying without really even knowing it. Many people don’t bother to check these details, and lose out significantly because of it.

    Also, I would say that the safety of over-diversification is something that would outweigh any decrease in gains incurred.

    • Anonymous

      I agree Tyler. I am disccusing in another post that people need to look at the details of mutual funds before committing to them. You need to know what the expense ratio is and if it is a loaded fund or not. I agree that over-diversification is sometimes a problem, but you also need to make sure that you are going to have safe returns. Historically, mutual fund investors do much better than individual investors do.

  • http://artofcheap.blogspot.com/2010/10/in-business-for-yourself-being-your-own_30.html Marc

    The advantages of mutual funds far outweigh the disadvantages when it comes to investments. For most people who are planning their financial futures, mutual funds are going to be their primary investment vehicle and they deliver most of the time where others investments fail. The secret to the growth of value in any given mutual fund is compound interest + regular deposits from your income source. Over time (20 years or more) the returns become ridiculous. Mutual funds are practically every man’s way to riches.

    • Anonymous

      I like what you said about being a possible route to riches Marc. However, I need to caution that there is never a guarantee with anything and plenty of mutual funds went bankrupt in 2008. They may definitely be one of the safer investments, but you still have to be careful. Also, like you said, you only make a lot of money in the long-term.

  • http://artofcheap.blogspot.com/2010/10/in-business-for-yourself-being-your-own_30.html Marc

    The advantages of mutual funds far outweigh the disadvantages when it comes to investments. For most people who are planning their financial futures, mutual funds are going to be their primary investment vehicle and they deliver most of the time where others investments fail. The secret to the growth of value in any given mutual fund is compound interest + regular deposits from your income source. Over time (20 years or more) the returns become ridiculous. Mutual funds are practically every man’s way to riches.

  • http://www.fromjoetojack.com/ Eric Scott

    This is the most in depth article I’ve ever read on mutual funds. Excellent job — thank you!!

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