Mutual funds enable investors to gain access to dozens or hundreds of investment securities, such as stocks or bonds, in one single security. To invest in mutual funds, first learn the different types of funds available and then buy shares through a brokerage account.
Mutual Fund Basics
A mutual fund is a professionally managed fund that pools cash from investors. With this cash, the fund’s manager buys securities, called holdings, that combine to form the fund’s portfolio. To invest in a mutual fund, an investor buys shares, which represent part ownership in the fund, as well as any income that the fund may generate.
Mutual funds can be actively managed or passively managed. Active management involves the fund manager buying and selling securities at their discretion, while passive management means the fund is attempting to replicate the performance of an index. Mutual funds holdings can be from various asset classes, including stocks, bonds, and commodities.
Important: When an investor sees or hears the term “mutual fund,” it is most often in reference to an open-end fund. With open-end funds, mutual fund units are created and redeemed by the fund company; unitholders of the fund may cash in their units at the end of any trading day, at their Net Asset Value. This is different than closed-end funds, stocks, and ETFs, which trade on the secondary market on a exchange, and can only be exchanged with other buyers and sellers.
5 Steps to Invest in Mutual Funds
The 5 steps to invest in a mutual fund are:
1. Choose a Financial Institution
Investors need to decide what Financial Institution they would like to deal with. Charles Schwab, E*Trade, Robinhood, and others, offer discount brokerage accounts. However, in some cases, it’s also possible to invest directly with the mutual fund company.
2. Open a Trading Account
Investors can choose to open a standard brokerage account or a retirement account, such as an IRA. The accounts can be opened with a discount brokerage company or a full service broker. Full service brokers provide advisory and portfolio management services but charge higher commissions.
3. Fund the Account With Cash
Before buying a mutual fund, or any other type of investment security, an investor will need to add money to what is called a core account or settlement account. This is typically a money market account and can be funded easily online through ACH payment or electronic funds transfer.
4. Research Mutual Funds and Alternatives
Investors may choose to research alternatives to mutual funds, such as a ETFs, or build their own portfolio of securities, such as stocks, bonds, or a combination of these securities.
5. Place the Trade
Investors can buy shares of a mutual fund in a similar way as a stock or ETF; however, there are some differences in how they trade. For example, mutual funds do not trade intra-day at a prevailing market price like stocks and ETFs. Instead, mutual funds transact only at the end of a market day at the ending net asset value, or NAV.
Important: While most mutual funds can be transacted in commission free, some mutual funds can have transaction fees or sales charges. All mutual funds have a management expenses ratio (MER) that is stated as an annual % and charged daily.
Evaluating and Comparing Funds
When researching and analyzing mutual funds, investors typically compare a few primary selection criteria, such as performance and fees. Depending on the fund type, investors may dig deeper into other details, including the funds’ benchmark, holdings, manager tenure, turnover ratio, tax-efficiency and various risk measures, such as alpha, beta, standard deviation, R-squared and Sharpe ratio.
Measures for comparing mutual funds include:
- Past performance: Typical periods to compare are 1-, 3-, 5- and 10-year returns. Long-term investors are generally more interested in comparing longer periods of time, such as 5- and 10-year returns, because these periods tend to cover a full market cycle.
- Fees: The primary comparison to make are the funds’ expense ratios, which is the percentage cost charged to unitholders for operating of the fund. Lower expenses are generally superior and can translate to higher long-term returns. Some funds have sales charges, also known as loads.
- Holdings: Some investors may be interested in specific securities or a certain degree of holdings concentration or diversification within a fund. Therefore, certain investors may wish to compare the list of holdings and number of holdings within funds.
- Manager tenure: Management tenure at a particular fund may be important to some investors, especially for actively managed funds. A fund’s long-term historical performance may be less meaningful if there was a recent change in the fund manager.
- Turnover ratio: Investors may wish to study the percentage of a portfolio that has changed during a given year. Generally, a lower turnover ratio is superior because it may translate into lower costs of managing the fund and can reduce taxable distributions to the investor.
- Tax-efficiency: Taxation can reduce an investor’s after-tax returns. For investors holding mutual funds in taxable accounts, keeping taxes low may be a high priority. Funds that pay little or no dividends, and funds with low turnover ratios, generally have greater tax-efficiency.
- Beta: Beta is a measure of volatility compared to the market as a whole. The market beta is 1.0. Some investors may prefer less risky and less volatile investments than the overall market. in which case they may seek a fund with a portfolio beta lower than 1.0.
- Alpha: Alpha represents the excess investment return above what is expected for a given level of risk. Funds that generate positive alpha are generally seen as superior.
- R-squared: Investors may be interested in how closely a fund performs relative to its benchmark index. This can be assessed using a measure called R-squared. For example, a large-cap stock fund that moves in lock step with the S&P 500 would have an R-Squared measure of 100.
- Standard deviation: A statistical reading that measures overall price volatility of a fund. The higher the standard deviation, the more volatile the fund has performed.
Tip: When comparing mutual funds, it’s important to attempt “apples-to-apples” comparisons. For example, a large-cap value fund that has underperformed an emerging markets fund may not be indicative of poor fund management. It’s possible that this large-cap value fund is in fact one of the top performing funds of its kind.
Mutual funds are professionally managed portfolios that use pooled cash from investors to buy securities to be held in the portfolio. Despite professional management, not all mutual funds are equal. Investors should carefully consider what type of mutual fund may best suit them, and then evaluate the various specific funds that appeal to those particular objectives.