How Mutual Funds Work

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Mutual funds are a good way to begin investing.  Photo by BraunS/Getty Images

A mutual fund is a collection of stocksbonds, or other securities. When you buy a mutual fund, you own the share of the mutual fund. The price of each mutual fund share is called its NAV, or net asset value. That's the total value of all the securities it owns divided by the number of the mutual fund's shares. Mutual fund shares are traded continuously, but their prices adjust at the end of each business day.

Stock Funds

Stock funds focus on corporations that are publicly traded on one of the stock market exchanges. Some mutual funds invest according to the company's size. These are small, mid, or large-cap funds.

Others invest in the type of company. Growth funds focus on innovative firms that are rapidly expanding. Value funds focus on companies that others may have overlooked. Similarly, high tech funds may also have a lot of growth companies. Blue chip funds also have many value companies. You may want a fund that focuses on companies that issue dividends. Many of these are also blue chip or value companies.

Many funds focus on geographic areas. Domestic funds only buy companies that are U.S.-based. International funds can pick the best-performing countries anywhere in the world. Emerging market funds focus on good companies in Russia, China, and other countries in the MSCI Emerging Markets Index.

Frontier markets target smaller nations like Argentina, Morocco, and Vietnam, 

You should invest in mutual funds instead of stocks if you don't want to research each company's financial statements. Mutual funds also provide instant diversification. For that reason, mutual funds are less risky than individual stocks.

If one company goes bankrupt, then you don't lose all your investment. For that reason, mutual funds provide many of the benefits of stock investing without some of the risks.

Bond Funds

Bond funds invest in securities that return a fixed income. They became popular after the 2008 financial crisis. Investors who were burned during the 2008 stock market crash headed for safety. They were attracted to bonds despite record-low interest rates. 

The safest are money market funds. They buy certificates of deposit, short-term Treasury bills, and other money market instruments. Since they are so safe, they offer the lowest return. You can get a slightly higher return without much more risk with long-term government debt and municipal bonds

Higher returns and higher risks occur with corporate bond funds. The riskiest bond funds hold high yield bonds. As the Fed raises interest rates, it could trigger defaults. 

Some funds differentiate between short-term, medium-term, and long-term bonds. Short-term funds are safer but have a lower return. Long-term bonds are riskier because you hold them longer but offer a higher return.

Many bond funds own the same bonds. If one manager starts selling that bond, the others will do the same.

But there wouldn't be a lot of buyers for those bonds. Low liquidity would force prices down even lower. Bonds would be subject to the same volatility as stocks and commodities. It could . Examples of that scenario occurred during the bond "flash crash" in October 2014. 

Actively Managed Versus Exchange Traded Funds

All mutual funds are either actively-managed or exchange-traded. Actively-managed funds have a manager who decides which security to buy and sell. They usually have a goal that guides the manager's investment decision. The manager seeks to outperform their index by trading securities. As a result, their fees are higher. As a result, they must exceed both the index and their higher fees. 

Exchange-traded funds match an index. Since they don't need much trading, their costs are lower.

As a result, these funds have become more popular since the 2008 financial crisis.

Pros and Cons 

Mutual funds have less risk than buying individual securities because they are a diversified investment. That means you aren't as dependent on an individual stock, or bond, and its underlying company. If one of the companies goes bankrupt, you own many more stocks to protect your investment.

Actively-managed funds give you the benefits of professional stock picking and portfolio management. You don't have to research thousands of companies. The managers are experts in each field. It would be almost impossible for you to become an expert in all the areas in which you'd like to invest. 

But it still takes a great deal of time to research mutual funds. To make it worse, the managers of funds change. When that happens, it could affect the performance of your fund even if the sector is doing well. That's important because managers continuously change the stocks they own. Even if you look at the prospectus, it might not reflect current stock ownership. You don't know what you are buying specifically, so you are relying on the expertise of the manager.

The prospectus will warn that past performance is no guarantee of future returns. But past performance is all you have to go on. There's a good chance that a fund that's outperformed the market in the past underperform in the future. That's especially true if the manager changes.

The most significant disadvantage is that mutual funds charge annual management fees. That guarantees they will cost more than the underlying stocks. These fees are often hidden in several places in the prospectus. 

To pick good mutual funds, you've got to understand your investing goals. Are you saving for retirement or setting aside some extra cash for a rainy day? Stock funds would be best for long-term retirement investing, while a money market fund is best for short-term savings. Work with a certified financial planner. He or she will help you determine your best asset allocation and investment strategy. 

Mutual Fund Companies

Mutual funds are managed by hundreds of companies, who have hundreds of funds each. Most companies focus on specific strategies to stand out from the crowd. Here are the top 10 , with their approach:

  1. Vanguard - Low management fees.
  2. Fidelity - Full financial services.
  3. American - Conservative investment strategies that long-term investment timeframe.
  4. Barclays - Target professional, not individual, investors.
  5. Franklin Templeton - Bonds, emerging markets and value companies.
  6. PIMCO - Bond funds.
  7. T. Rowe Price - No load funds.
  8. State Street - Target professional, not individual, investors.
  9. Oppenheimer - Actively managed funds.
  10. Dodge & Cox - Long-term investment timeframe. 

How Mutual Funds Affect the Economy

Mutual funds are an essential component of the U.S. financial markets. A good mutual fund reflects how an industry or other sector is doing. Mutual fund values change on a daily basis. That demonstrates the value of the assets in the fund's portfolio. The economy is much slower moving so that wide variations in a fund don't always mean that sector is gyrating as much. But if a mutual fund price declines over time, then it is a good bet that the industry it tracks is also growing more slowly.

For example, a mutual fund that focused on high-tech stocks would have done well up until March of 2000, when the tech bubble burst. As investors realized that the high-tech companies were not returning profits, they started selling the stocks. As a result, the mutual funds declined. As the mutual fund and stock prices fell, the high-tech companies could not remain capitalized. Many went out of business. In this way, stock mutual funds and the US economy are inter-related.