The Mutual Fund in Simple Terms

Mutual funds are an important investment tool and a cornerstone of many portfolios. According to research from the Investment Company Institute (ICI), more than 115 million U.S. investors owned mutual funds in 2023, suggesting that more than half of American households rely on mutual funds to save and invest. “Funds have never been more important than they are today for people around the country to save for their future,” said Sarah Holden, ICI Senior Director of Retirement and Investor Research. “These are the middle-class, hardworking people who keep the country running.”

To those unfamiliar with financial markets, mutual funds may seem overly complex, but in essence, they simply pool money from multiple investors to form a diversified package of securities, like stocks, bonds, or other assets. Through this collective approach, individual investors can participate in a wide range of professionally managed investments.

How Mutual Funds Work

Individuals investing in a mutual fund combine their money with other investors. A professional fund manager then uses this collection of capital to purchase securities that align with the fund’s stated investment goals. An accompanying document known as a prospectus is a detailed accounting of these objectives, providing insights into the fund’s strategy, risks, fees, and performance history.  Reviewing the prospectus is the only way to understand the plan for accomplishing the mutual fund’s purpose.

The collective performance of a mutual fund’s underlying assets determines its overall performance, so if the securities within the fund do well, the value of the fund increases. Conversely, the value decreases if the assets underperform. There are three primary ways investors can earn returns from mutual funds:

• Income from dividends: In this instance, certain securities yield dividends within a fund or pay interest. The fund can then periodically distribute this income to investors.
• Capital gains distributions: If a fund sells securities at a profit, the proceeds can be distributed annually to investors.
• Increased net asset value (NAV): An investment fund’s NAV calculates its per-share value by subtracting all liabilities from the fund’s total asset value, revealing its true worth. If the market value of the fund’s holdings rises, the fund’s NAV also increases. Investors can then sell their shares at a profit by selling at a higher price than they paid.

Types of Mutual Funds

There are many mutual funds, each with individual risk levels and investment goals. Some common categories include:

• Equity funds: These stock-focused investments aim for capital appreciation and concentrate on specific sectors, company sizes, or investment styles.
• Index funds: These funds intend to replicate the performance of a specific market index, like the S&P 500, by holding the same securities.
• Balanced funds: To balance the risk-return profile, these investments combine stocks and bonds for a mix of income and capital appreciation.
• Bond funds: These bond-heavy investments carry less risk than equity funds, and they serve to provide regular income.
• Money market funds: For those looking for low-risk, low-return investments geared toward preserving wealth, these funds also offer high liquidity and consist mainly of short-term debt securities.

Advantages of Mutual Funds

Investing in mutual funds has several benefits, including:

• Diversification: Because mutual funds pool resources to invest in assorted asset types, they spread risk across different securities and sectors.
• Professional management: Experienced fund managers save investors time and effort by researching, making investment decisions, and monitoring portfolio performance.
• Liquidity: At the close of each trading day, investors can buy, sell, or exchange mutual fund shares at the fund’s current NAV.
• Accessibility: Mutual funds are widely accessible to investors because they have relatively low minimum investment requirements.

Considerations and Fees

Despite the numerous advantages mutual funds offer, there are also notable costs and considerations as follows:

• Fees and expenses: The costs associated with mutual funds, including management fees, sales charges (loads), and operating expenses, can affect returns. These costs vary significantly across funds, so investors should read and understand the prospectus.
• Tax implications: Mutual fund distributions, such as capital gains and dividends, may be subject to taxes. Furthermore, selling mutual fund shares can have tax ramifications.
• Performance variability: Past performance does not guarantee future results. Fund management decisions and market conditions can cause a fund’s performance to fluctuate.

Getting Started with Mutual Funds

For those contemplating investing in mutual funds, here are some steps to start on the right path.

1. Establish financial goals: Determine your investment objectives, timeline, and risk tolerance. Identify the purpose for adding mutual funds to your portfolio. ICI research found that 79% use mutual funds as part of their retirement saving strategy. Another possibility is building an emergency fund that allows easy access to cash.
2. Research funds: Explore different types of funds through reputable financial websites. Read each prospectus to understand the fund strategies, performance histories, and fees.  
3. Consult a financial advisor: When it comes to incorporating mutual funds into your portfolio, a financial advisor is the best source of information. They can provide personalized financial advice based on your circumstances and goals and help you select the appropriate funds.

Mutual funds are a valuable way to achieve professionally managed, diversified exposure to financial markets. At SHP Financial, we can help you understand how these funds work and carefully select those that align with your financial profile, circumstances, and initiatives so you can make sound investment decisions. For more information about diversifying your portfolio and a complimentary review of your finances, contact an SHP Financial advisor today.