Since the first mutual fund was launched in the mid 1920s, they have become one of the most popular investment vehicles.
Mutual funds are professionally managed funds that work by pooling together money from multiple investors to buy shares of stock, bonds, and other assets usually under the guidance of professional money managers. For investors, mutual funds are typically less risky than owning individual stocks since the money can be spread out between several companies and industries.
Types of mutual funds
As the asset management industry has expanded over time, so have the different variations of mutual funds that are available to investors. Mutual funds can invest in broad areas of the stock market or more niche asset classes like commodities.
Each type of fund has its own unique characteristics and comes with varying levels of risk, potential for return, and purpose. Below we will explore some of the most common types of mutual funds that are available and compare their benefits and drawbacks.
Asset allocation funds
Asset allocation funds are designed to let investors own a specific blend of stocks, bonds, cash, and other securities. Asset allocation funds work by establishing a target allocation and rebalances on a regular basis, usually monthly or quarterly.
For example, an asset allocation fund may have a target to own 60% in stocks and 40% in bonds. Each quarter, fund managers will ensure that these targets are met and will buy and sell holdings when needed to achieve the target. An investor may choose an asset allocation fund if they want to maintain a specific asset mix over time without the need to rebalance their portfolio on their own. Asset allocation funds can also be helpful for those who want a more hands-off automated approach to investing.
Pros:
- Can be the only investment in a portfolio and still provide an adequate level of diversification
Cons:
- The chosen allocation may not be a fit for the investor if their risk tolerance changes
Commodity funds
Commodity funds give investors the ability to invest in raw materials, such as metals like gold and silver, natural resources like oil and natural gas, or agricultural products like soybeans, wheat, or corn.
Most mutual funds are a mix of stocks and bonds, but commodity funds can be a bit more diverse. For example, an oil commodity fund can own shares of several oil related companies. But it can also own futures contracts or a combination of both. A futures contract is a legal agreement between two parties to buy or sell an asset, such as a commodity or security, at a predetermined price on a specific date in the future.
Because price movements of commodities can be uncorrelated to stocks, they can add a different layer of diversification than other alternatives like bonds or real estate.
Pros:
- Added layer of diversification in a portfolio
- Generally resistant to inflation
Cons:
- Commodity prices are highly volatile, making them very risky investments
ESG funds
ESG stands for environmental, social, and governance, since these funds are designed to invest in companies that meet certain sustainability criteria.
- Environmental is commonly defined as companies that take into account how their operations impact the climate.
- Social considers companies with ethical practices such as diversity and inclusion, human rights, and labor laws.
- Governance measures a company's internal controls and procedures to ensure proper corporate operations.
ESG funds try to focus on investing in businesses with a positive environmental or social impact while still generating financial returns. Like most mutual funds, the fund managers decide what investments the fund will hold, what makes ESG funds different is that fund managers judge each of the funds holdings against an additional rubric based on a variety of factors such as the company’s carbon footprint.
Investors who are concerned about the impact of their investments on the world and want their investments to align with their ethical values may find ESG funds more attractive.
Pros
- The funds holdings may have less financial risk due to the higher governance standards
- May add a new layer diversification to your portfolio but varies by fund
Cons
- Not all ESG standards are the same, some holdings may be included that you do not agree with
- Less history and data on long-term performance outcomes
- May carry higher expenses
Equity funds
Equity funds are mutual funds that have their primary holdings in stocks. These types of funds are very common and can range from a specific sector such as technology or health care, but can also overlap into other categories as well.
"They allow you to invest in lots of securities all at once rather than needing to pick each individual security on your own," says Bryan Stiger, certified financial planner at Betterment. "For a small fee, you can have professionals build your portfolio."
An investor may choose equity funds for a few reasons. First, equities historically grow at a higher rate than inflation and most fixed income investments like bonds. Second, equity funds provide the ability to invest in multiple stocks at once instead of choosing stocks one-by-one. "Think of it like grocery shopping. If you walk through the entire store picking all your own food. Over time, it can be difficult to consistently create a balanced diet," Stiger says.. "Wouldn’t you rather pay a small fee to have a professional do all the shopping for you to maintain a balanced diet over time? That’s why people invest in mutual funds."
Pros
- Can offer growth and diversification for an investor
- Less risk than choosing individual stocks
Cons
- Fees may be higher than passively managed funds
- Equity funds tend to underperform most index funds
Fixed income funds
The term fixed income refers to an investment that pays out a set amount to its investors. Bonds are the most often associated with fixed income but it could also include mortgage-backed securities and U.S. Treasury Notes.
When you invest in a bond fund, for example, the value of your investment can fluctuate based on changes in interest rates, credit quality of the bonds held within the fund, and overall market conditions.
The benefit for shareholders is that it makes fixed income more accessible as individual bonds are not as common for investors to buy and sell. Generally, investors choose fixed income funds for steady performance and lower volatility compared to equity funds but this trade off comes with a lower return versus equities.
Pros
- May reduce volatility and risk for your portfolio
- Simple to manage compared to single fixed income investments
- Generally considered a hedge against market downturns
Cons
- Lower returns compared to index and equity funds
- Sensitive to credit risks if the issuing entity cannot pay back its bond obligation
Index funds
An index measures the performance of a group of securities such as stock or bonds. That’s because it’s designed to replicate the performance of an index, such as the S&P 500, Nasdaq 100 for equities, and the Bloomberg US Aggregate Bond Index.
Instead of a fund manager deciding what assets to buy and sell, index funds are passive and the money is split between each of the holdings within the index. "Passive funds have good transparency related to what they are investing in, since by definition they track an index," Stiger says. An investor may prefer index funds because of their potential for lower costs, diversification, and history for outperforming actively managed funds.
Pros
- Fees are generally lower than actively managed funds
- Outperforms most actively managed funds
- The holdings are transparent
- Widely available in most retirement accounts and investing apps
Cons
- Can only match the performance of an index but unlikely to outperform
- Cannot control over which stocks are added or taken out of the index
Money market funds
A money market fund invests in short-term debt assets, such as certificates of deposit (CDs) and treasury bills (T-bills). These funds are designed to provide a stable return while preserving capital, making them an attractive option for investors who want a low-risk option with marginal returns. "Money Market funds are typically viewed as a cash investment and a store of value. While [equity] mutual funds are viewed as a way of growing your investment or giving you some type of capital appreciation," says Stiger.
An investor generally uses money market funds to hold cash before the funds are invested or as a way to gain a bit more interest than a bank account. Keep in mind that while the names are similar, money market accounts that you would typically find at your bank or credit union are not the same as a money market mutual fund. The former is backed by the FDIC, while the latter is not.
Pros
- Low risk, low volatility investment option
- Offers high liquidity
Cons
- Low returns
- Not FDIC insured
Target date funds
Target date funds are a type of mutual fund designed to help investors reach their long-term investing goals based on the year they plan to retire. These funds invest in a mix of stocks, bonds, and other investments that are tailored to an investor's goals, time horizon, and risk tolerance.
Many target date funds, sometimes known as lifecycle funds, will have a year attached to the fund name. An example is the Vanguard Target Retirement 2035 Fund Target (VTTHX), the “2035” indicates the year that shareholders plan to retire should they invest in this fund.
Target date funds typically are more aggressive in the early stages and become more conservative as the investor gets closer to their retirement date automatically. These types of mutual funds may be attractive for investors who are looking for a “one-stop-shop" approach to investing.
Pros
- Ease of use; no need to monitor investments or rebalance your portfolio
- Widely available within retirement accounts
- Suitable for retirement investors who have limited time and knowledge of investing
Cons
- Limited customization to individual investors
- Potentially higher fees and index funds and other mutual funds types
Active vs. index funds
The debate between actively managed funds and index funds, which are passively managed, has been on the minds of investors and academics for decades. “Active funds are run by a fund manager whose objective is to generate a higher return than the index,” says Allen Mueller, CFA, MBA, founder of 7 Saturdays Financial.
On the other hand, index funds are passively managed and follow the performance of an underlying index. “Academic studies show that at least 85% of funds fail to beat their benchmark after fees,” says Mueller. Actively managed funds also tend to cost more. In 2018, the Investor Protection Bureau of New York found that actively managed funds cost investors 4.5 times more per year on average.
Mutual funds fees and costs
One of the most important things to consider when investing in any mutual fund is cost. Below are the most common types of fees found in most mutual funds. Always refer to the fund's prospectus to see which fees are associated with the fund you're considering.
Expense ratio: Also referred to as operating expense ratio (OER), the expense ratio is the amount taken each year to cover the fund's operating costs. This cost is expressed by a percentage. For example, the expense ratio for the Vanguard Total Stock Market Index (VTSAX) fund is 0.04%. If you had $10,000 invested in this fund, it would cost $40 per year.
Load fee: The load fee is an upfront, one-time amount charged by some funds when you buy or sell shares of the fund. These fees usually compensate the broker for their expertise and knowledge in selecting and suggesting the fund to the investor.
Transaction fee: This fee may be incurred when buying or selling shares of the fund but are usually charged by some brokerage firms.
In addition to the fees listed above, there are also different share classes. Mutual fund share classes refer to different versions of the same mutual fund that have different fee structures and minimum investment requirements. Each share class will also have its own unique ticker symbol as well.
Class A
This share class usually has a front-end load, meaning the full price is paid once you buy shares of the fund. That fee is usually split between the mutual fund company and the broker.
Class B
Generally has a back-end load or deferred sales charge that decreases over time but has higher ongoing annual expenses.
Class C
This share class typically does not have a load but will have higher ongoing fees based on the amount you have invested.
The takeaway
When investing in mutual funds, there can be a lot of factors to consider. To help simplify your decision making process, start by assessing your values as an investor. "It’s important to evaluate one’s own risk tolerance," says Stiger. "Ask yourself if you can stomach returns that lag the market for periods of time for the potential higher returns in the long-run. If seeing periods of underperformance will bother you, then you should probably look to invest in index-funds."
