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What Is a Mutual Fund?

May 27, 2014

A mutual fund is a simple way to invest in a diversified portfolio. Funds pool the money of many investors, and then a manager chooses stocks, bonds or other assets for the fund to hold. Most funds hold only stocks or only bonds, but balanced or target-date funds will mix the two kinds of assets.

The main advantage of a fund is that it allows you spread your market bets with a small amount of money. For example, with a minimum initial purchase of around $2000 to $3000, you can buy a fund that holds all 500 stocks on the S&P 500 index. You can then build your position with subsequent investments of as little as $50. If you are investing in funds via a workplace 401(k), you’ll face no minimum at all. You would need many thousands of dollars to build your own widely diversified portfolio stock-by-stock.

Most mutual funds are “actively” managed. That means the fund’s manager chooses the investments he or she thinks will provide the best return, within the constraints of the fund’s style. For example, some funds aim to hold low-risk, large companies, while others might focus on small, high-growth companies with wilder price swings.

Managers charge a price for this service: You will typically pay between 0.75% and 1.5% of assets per year in expenses for an active stock fund. Bond funds are usually cheaper. You never pay a bill for these costs—they are raked off of the top of your investment. If your fund earns 3% on its investments in a year, but charges 1%, your net return is 2%. If it loses 3%, you actually lose 4%.

Some funds sold through advisers or brokers will also carry a sales “load.” A load might be an up-front fee of 4% on each dollar you invest. Or it may be a deferred load, in which you are charged less at the start, but pay higher annual expenses each year.

A much cheaper option is the “passive” index mutual fund. These funds simply mimic an index, such as the S&P 500 list of the largest U.S. companies. Since the manager isn’t researching investments or making any decisions about which stock or bond is better than another, the cost of an index fund can be very low. A fund that tracks the average of the entire U.S. market may cost just .05% to .15% per year. Over time, these lower costs give index funds a huge advantage over active funds.

