What is a mutual fund? Basics, pros and cons

What are mutual funds?

The definition of a mutual fund is an investment that pools your money with that of many other people who share similar investment goals. Professional money managers use the pool of money to buy securities that can help achieve the mutual fund's specified objectives.

Mutual funds may be an appropriate retirement investment because they offer professional management and diversification. They are not FDIC insured and involve investment risks, including possible loss of principal and fluctuation in value.

What are the types of mutual funds

There are a variety of types of mutual funds, but they usually fall under one of the following four categories:

• Equity (stock) funds: These are funds that are invested in corporate stock of publicly traded companies. These funds can be classified based on a variety of components, including company size, industry or sector type, or based on potential growth and value.
• Bond funds: These are made up of debt instruments that the government or corporations issue to investors to raise capital. They often carry less risk than stock funds; however, they may have less potential for growth.
• Money market funds: These types of mutual funds invest in cash or cash-equivalent short-term debt from entities like the government or corporations. Money market funds are generally considered to be a low-risk investment.
• Hybrid funds: Hybrid funds are comprised of at least two or more asset classes—typically a blend of stocks and bonds. One of the most popular forms of hybrid funds is called balanced funds, which is a type of portfolio that invests 60% in stocks and 40% in bonds.

Pros and cons of mutual funds

Mutual funds can be an efficient and cost-effective means of investing money. Some pros and cons of investing through mutual funds may include:

Pros

• Diversification: When you invest in mutual funds, you have the opportunity to invest in a variety of different types of stocks and bonds from a number of industries. This strategy exposes you to less risk than purchasing individual securities, as one holding’s poor performance may be offset by others performing well.
• Small investment amounts: While your investment strategy depends on your funds’ rules, you may be able to make smaller contributions that can grow over time.
• Professional money management: Mutual funds provide professional management, ongoing supervision of your holdings and automatic diversification – all important elements of a well-rounded investment strategy.
• Liquidity: Because shares can be redeemed on any business day, mutual funds provide liquidity—and because shares of a mutual fund are priced daily, you always know the value of your investment. Because investment returns and principal values will vary with market conditions, an investor's shares may be worth more or less than their original purchase price.

Cons

• Potential for loss: Mutual funds are not FDIC insured and may lose principal and fluctuate in value.
• Cost: A mutual fund may incur sales charges either up-front or on the back end that are passed on to the investors. In addition, some mutual funds can have high management fees.
• Tax implications:
  • Dividends and interest payments are generally considered taxable income by the IRS even if you reinvest the money.
  • If you earn a profit from the mutual fund either through the sale of all or some of your shares or if the fund managers sell securities in the fund for a profit, the IRS generally considers your profit a capital gain which is taxable income even if you reinvested the money.
  • If these situations apply to you, you will likely receive a 1099-DIV or 1099-INT to report the income to the IRS.

When should I start investing in mutual funds?

One of the basics of mutual funds is that the sooner you start investing, the longer your money can work for you. Investing regularly can also make a positive difference over time, a concept known as dollar-cost averaging.

Dollar cost averaging is a method of investing that helps reduce the risks of market timing by investing a fixed amount at regular intervals.  When prices are low, your investment purchases more shares. When prices rise, you purchase fewer shares. Over time, the average cost of your shares will usually be lower than the average price of those shares. It does not assure a profit or protect against losses in a declining market.  However, over longer periods of time it can be an effective means of accumulating shares. Investors should consider their ability to continue investing through periods of low market prices.

Learn more about dollar-cost averaging and other strategies to help you reduce investment risk.

Basics of investing in mutual funds

The first step in understanding the basics of mutual fund investments is to determine your goal(s). Then, evaluate your risk tolerance and eliminate funds that don’t align. Once you have a list of funds that meet your goals and risk tolerance, review their prospectus to ensure the funds' investment objective and risk level meets your individual investment goals. An Ameriprise financial advisor can help you evaluate your goals and risk tolerance and select the appropriate funds that fit your needs and situation.

Understanding a mutual fund’s performance

An Ameriprise financial advisor can help you understand performance factors for mutual funds, including:

• Past performance: While historical performance is not a guarantee of future results, understanding fund’s previous performance provides valuable context – including its performance during market highs and lows.
• Turnover ratio: The value of a fund’s trades in a year compared to its total value of assets. For example, if one mutual fund invests in 50 stocks and that year replaces 20 of those, the turnover ratio would be 40%. Funds with higher turnover ratios tend to be more expensive than those with lower turnover rations due to commission costs accrued when buying and selling stocks.
• Operating fees, sales charges and other expenses: Investors may pay annual operating fees, shareholder fees and other fees and penalties
  • Annual operating fees are also known as the expense ratio which can be calculated by dividing a fund’s annual expenses by its average net assets. The higher the expense ratio, the higher the cost to the investor.
  • Shareholder fees or sales charges, commissions and redemption fees are also known as either a front-end load or back-end load depending on whether they’re assessed at the time of purchase or the time of sale.
  • There may also be charges for early withdrawals or selling the holding early.

Mutual funds definitions

Below are definitions for basic mutual funds terms:

What is a fund share?

A fund share represents a portion of all the securities (stocks and bonds) owned by the fund. The prices of these securities may change daily, so the value of your fund share may change daily, too.

What does NAV mean?

NAV stands for the “Net Asset Value” of a stock. It’s the price at which one share was sold to the public as of the previous business day's market close. The NAV of a mutual fund is determined by adding the value of all the securities in the fund's portfolio, subtracting debts and expenses and dividing the result by the total number of shares outstanding.

What does “total return” mean?

Total return is a measure of a fund's performance including reinvested dividends and capital appreciation. Listings may be calculated for different time periods—often weekly. Check for the durations being used.

Why should I have a diversified portfolio?

Diversification, or spreading your assets among a variety of investments, can help mitigate the potential risk and volatility of owning a single stock or investment. A diversified portfolio can increase your opportunities for achieving long-term growth — but that diversification does not guarantee a profit or prevent losses to your portfolio.

Work with an Ameriprise financial advisor to determine if mutual funds are right for you

As with any investment type, there are pros and cons with any form of mutual funds investment. An Ameriprise financial advisor can help you determine if mutual funds are right for you to help you meet your financial goals.

If you would like to see if a particular type of  mutual fund is available at Ameriprise Financial, search for it by name or ticker using the Mutual Fund Screener tool. You can use the tool to view a complete list of mutual funds and fund families available at Ameriprise Financial.