Mutual funds – going beyond the basics

If you’ve read Mutual Fund Basics, we’d like to introduce you to some of the concepts you’ll encounter as you look deeper into mutual funds.

First, a quick review: A mutual fund is a type of investment that lets small investors pool their money together into a “fund.” Using that big pool of money, the fund can diversify risk by purchasing multiple investments such as stocks, bonds, real estate, and precious metals — many more investments than one investor could afford. The mutual fund is run by a professional fund manager who decides what investments to buy and sell and the fund’s investment strategy (such as long-term growth or real estate sector). Information about the fund, its investments, performance, strategy, and its manager can be found in the fund’s prospectus.

If you are an investor in the fund, you own a piece of the entire portfolio of investments. You share in the growth or loss and any income paid out by the investments. You also share in the taxes due, the costs to manage the fund, the transaction costs, and, if it applies, in commissions or fees paid to dealers and agents.

The three basic types of funds: stock, bond, cash

Stock (equity) fund

Invests in companies that issue stock. The aim of the fund is to grow your investment over time and possibly provide income. Risk ranges from moderate to very aggressive (takes big chances for possibly big returns). Stock funds are categorized by investment style such as growth, sector, geographic area, and company size.

Bond (fixed income) fund

Primarily aims to provide income payments by investing in government and corporate bonds. Bonds represent loaned money and are subject to credit risk. Risk varies depending on the type of bonds the fund invests in.

Cash equivalent (money market) fund

Invests in government securities and other cash equivalents for lower risk — and low return. In addition to providing a lower risk investment for your portfolio, money market funds are often used as holding areas until something better comes along.

How the fund is managed affects the costs passed on to you

Actively managed fund

The fund manager (which includes staff, overhead, and resources) is paid to research investments and then buy and sell them in an attempt to achieve the fund’s stated goal. These costs make up a portion of the expense ratio and should be taken into consideration when evaluating a fund. When evaluating expense ratios, the lower the expense, the less impact it will have on the fund's performance over time.

Passively managed (Index) fund

Attempts to duplicate the performance of a market index such as the S&P 500 by investing in the same securities in the same proportions as the index. Because the list of stocks is already determined and there is no active trading or management, the expense ratio is typically lower than actively managed funds.

Asset allocation funds do the heavy lifting for you

Asset allocation

Asset allocation is how you diversify your investment portfolio to spread risk. By spreading money across multiple asset types, sectors, and geographic areas, investors may be able to decrease their chance of experiencing large market swings while bolstering potential long-term returns.

Asset allocation fund

With an asset allocation fund, an investor picks the fund with the investment mode they feel comfortable with: growth, moderate growth/income, or conservative. Then according to fluctuations in the market, the fund manager buys and sells stocks, bonds, and money market funds to maintain that preference. Often used as the “single choice” retirement investment option, this high level of hands-on management can translate into higher fees.

ETFs are like Index funds, only different

ETFs (Exchange-Traded Funds)

Similar to an index mutual fund, ETFs mirror a market index making them passive investments that may have lower expense ratios than actively managed funds. When comparing an ETF to a comparable index fund, look at the trading fees. There may be a difference because ETF shares are traded all day, like a stock, while a mutual fund is only bought and sold at the end of the trading day.