Mutual funds are investment vehicles widely used by many Americans.
Mutual funds are a common offering across many company-sponsored 401 (k) plans. As you work on your retirement plan, it can be helpful to understand the fundamentals of mutual funds to determine if this is an option you might want to invest in.
BASIS OF THE MUTUAL FUND
According to the Securities and Exchange Commission (SEC), a mutual fund is a company that pools money from many investors and invests it in stocks, bonds, and/or other securities. This creates a portfolio of stocks from which investors can buy stocks. Each share represents the partial ownership of an investor in the fund portfolio and the right to receive a portion of the profits or income from those shares. In short, when you invest in a mutual fund, you are entitled to some of the profits (or losses) such as dividends and interest income, according to the SEC.
One of the many benefits of mutual funds, according to the Financial Sector Regulator (FINRA), is built-in diversification. That said, mutual funds can invest in a variety of securities, which reduces the associated investment risk. Keep all or most of your money in one investment. Owning stocks of mutual funds allows you to allocate your money over a variety of stocks or other securities.
In general, investment funds can be classified as follows according to FINRA:
Equity funds invest in stocks. Some funds may try to cover only a specific industry or sector, such as Tech or Healthcare, while other equity funds may seek broader diversification across an entire stock index such as the Standard & Poor's 500 or the NASDAQ . Others may invest in certain regions of the world, such as a European or Asian equity fund.
Pension funds, as the name suggests, invest in bonds. Much like equity funds, they can focus on a specific type of bond, such as municipal or global bonds.
Balanced funds invest in a combination of stocks and bonds.
ACTIVE VS. PASSIVE MANAGEMENT
Another distinction between mutual funds to consider is whether a fund is actively or passively managed.
According to FINRA, when a fund is actively managed, it employs professional portfolio managers to select investments with the aim of outperforming the market. These funds can be a good option for investors who are looking for professional selection and management of their fund investments. However, the SEC and FINRA note that actively managed funds often have higher fees, in part due to professional portfolio management.
In contrast, according to FINRA, passive funds are not actively managed, they simply seek to mirror and replicate (not outperform) the returns of the index they track. For example, the manager of a fund that mirrors the S&P 500 would simply buy a portfolio of shares of that index in equal proportions to replicate the holdings of the S&P 500. Because the fund only reflects the index and does not employ any professionals to make decisions. For active mutual funds, passive funds like these often have much lower fees.
Ultimately, the question of which mutual fund (or mutual fund) you want to invest in is very individual and based on your tolerance for individual risks and other financial factors. And since mutual funds are offered in most self-directed 401 (k) or IRA plans, they are also a convenient starting point for retirement investments.
Before deciding which funds are right for you, talk to your financial professional and read a fund's information kit called a prospectus.