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Mutual funds are one of the most popular investment vehicles for individual investors. Some are buying mutual funds through their employee-sponsored retirement plans, while others are buying them on their own in an IRA or brokerage account.
However you do it, there are plenty of good reasons to invest in mutual funds, most notably their built-in diversification. But when you decide to get started, you’re left with the decision of what types of mutual funds to invest in.
There are four primary types of mutual funds, and there are even more if you consider the specialty funds that exist. However, don’t let that keep you from getting started. Once you understand investing, you can start setting yourself up for financial independence. In this article, you’ll learn the different types of mutual funds and how to get started investing.
What Are Mutual Funds?
A mutual fund is a pooled investment that allows you to invest in many different securities with a single investment. This means you put your money in and your money gets spread out within the stock market. It’s also known as diversification.
Mutual funds allow investors to spread out their portfolio and avoid investing only in individual stocks, bonds, and other securities, which expose the investor’s portfolio to loss if the performance of an individual stock drops. Experts agree that diversification is key to wealth building.
“A mutual fund is a way to get access to small pieces of many investments, which helps ensure you’re diversified,” says Erin Lowry, the author of Broke Millennial Takes on Investing.
Mutual funds come in two flavors: they are either actively or passively managed. An actively managed mutual fund is one with a fund manager who regularly buys and sells securities to improve the fund’s performance. The goal of an active mutual fund is to try and beat the stock market, so there is a lot of buying and trading going on.
A passively managed fund is a lot simpler. It tracks the performance of a particular index or even an entire market, and doesn’t try to outperform the index. With passive investing, the name of the game is long-term holding, so there isn’t a lot of buying and selling going on. This keeps costs low for the investor.
The best way to invest in a passive fund is through an index fund that follows a large number of companies, such as the S&P 500, which follows the 500 largest companies in the stock market. It’s important not to get discouraged when the market takes a downturn, which is why a buy-and-hold mentality is so important.
Most experts recommend the passive approach when investing in mutual funds. Passive funds are cheaper, and many studies have shown that active fund managers rarely beat the market over time.
Why are there different types of mutual funds?
There are many different types of investments, investment objectives, and levels of risk. And while all mutual funds provide diversification in a particular asset class — or across multiple asset classes — they each have a different strategy. The option of different types of mutual funds allows all investors to find that that suits their risk tolerance, financial goals, and investment preferences.
Types of Mutual Funds
When you decide to add mutual funds to your portfolio, you’ll have several types to choose from. Each type of fund comes with its own advantages, risk level, and downsides.
Before you invest in a mutual fund, check the fees that come with it. These are also known as an expense ratio. Anything under .2% is considered a relatively low fee; anything over 1% is high. The lower the expense ratio, the higher your returns will be.
“Some mutual funds specialize in a specific asset type, such as equities or bonds, while others diversify their portfolios,” said Hutch Ashoo, the founder and CEO of Pillar Wealth Management, a financial planning firm.
An equity mutual fund is also known as a stock fund and it invests entirely in corporate stocks. Equity funds are the most popular types of mutual funds. Some equity funds may seek to track the performance of the entire market or a specific market index, like the S&P 500. It allows for diversification in your portfolio since you are invested in a large number of stocks.
A bond fund is one that invests in debt securities issued by corporations and government entities. Some may specialize in holding just corporate bonds, others may hold only government bonds, and others may be a mix of both.
Bond funds can have many different risk levels depending on the maturity of the bond, who issued it, its credit rating, and more. Bond funds are generally considered safer than equities, which also means they often have generally lower returns. But they often earn a higher return than money market funds, which also invest in debt securities.
Money market funds
Money market mutual funds typically invest in low-risk debt securities. In fact, federal law requires that they only invest in certain short-term, high-quality investments.
Investments you may expect to find in a money market fund include U.S. Treasury bills, certificates of deposit (CDs), commercial paper, repurchase agreements, and more. Some may specialize in only holding short-term government securities, while others are broader.
Money market funds are often considered a relatively safe place to park money, but because of their low returns compared to other mutual funds, they may not be appropriate for building wealth or preparing for retirement.
A balanced fund, also known as a hybrid fund, is one that invests in a mix of stocks, bonds, and other assets. They provide even greater diversification than a simple equity or fixed-income fund.
A common example of a balanced fund is a target date fund, which tracks a particular retirement date and adjusts its holdings over time according to how many years until the date associated with the fund.
A target date fund “automatically selects and reallocates assets toward safer investments as you draw closer to retirement,” Ashoo said.
Other mutual funds
While the four types of mutual funds listed above are the primary types, there are also plenty of more niche mutual fund categories. Other types of mutual funds you may come across or invest in include:
- Commodity funds: A commodity fund is one that invests in physical assets like precious metals, energy resources, agricultural products, and more. While commodities aren’t one of the primary asset classes for investors, they are a major alternative asset class.
- Socially responsible funds: An increasing number of investors are seeking to invest in a way that aligns with their personal values. Socially responsible funds may seek to invest in companies that work to make positive social and environmental change while avoiding investing in companies that aren’t in line with those goals.
- Sector funds: Some mutual funds specialize in investing in particular sectors. For example, you find a mutual fund that holds tech stocks, one that holds healthcare stocks, and more. For every major industry, there are mutual funds that specialize in it.
Why Invest in Mutual Funds
The primary benefit of mutual funds is the diversification they provide to your portfolio. While investing in a single stock or a handful of stocks could be profitable, it creates risk in your portfolio. If the one company you’ve invested in performs poorly — or worse, goes out of business — then you’ve lost your money.
When you invest in a mutual fund, you’re investing in many securities at once. As a result, your risk of loss due to the performance of a single company or industry is lower.
“A critical part to investing is having a diversified portfolio, which means you’re invested in many companies,” Lowry said. “Even more importantly, you want those companies to also be diversified. For example, you buy shares in five different tech companies. It’s great that you don’t have all your money invested in one company, but it’s not good that all those companies are in the same sector. Instead, you want to also have investments in companies that are outside of tech.”
Another reason why investors like mutual funds is that they’re great for any investor. As long as you keep checking in and making sure your investments are working for you, you can keep depositing money and let the account work on its own.
Mutual Funds FAQ
How do you invest in mutual funds?
You can invest in mutual funds through any major brokerage firm. Once you’ve chosen what fund to invest in, you can log into your account, search for the correct fund, and place your order.
What is the best type of mutual fund?
The best type of mutual fund for you depends on your investment goals, time horizon, risk tolerance, and the holdings currently in your investment portfolio. If you aren’t sure what type of mutual fund you should invest in, a financial advisor or investing service can help.
Are mutual funds safe?
Because of their diversification, mutual funds help to reduce the risk in your portfolio from what it would be if you invested in individual stocks. That being said, mutual funds, like all investments, carry some level of risk.
How much can you earn in a mutual fund?
The return of a mutual fund depends on what assets it holds and how the market is performing. The stock market has an average annual return of about 10%, which gives you an idea of what kind of earnings you might see in a stock market mutual fund. However, some mutual fund managers invest in the hopes of beating the market, while others invest in lower-risk securities to earn a below-market return.