What are mutual funds?

Explore how mutual funds — a pooled investment vehicle that invests in securities from various asset classes — can add to your portfolio.

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What are mutual funds?

Mutual funds are an investment vehicle that pools money from multiple investors to purchase a portfolio of securities such as shares, bonds, and other assets. A professional fund manager looks after the portfolio using their expertise to make investment decisions to pursue the fund’s objective.

When you invest in a mutual fund, you purchase shares of the fund, representing a portion of the fund’s overall portfolio. This entitles you to a percentage of the returns earned by the fund’s investments. 

The value of your shares in the fund will fluctuate based on the performance of the underlying assets held by the fund. Mutual funds are a convenient way for investors to access a diversified asset portfolio without managing investments themselves.

How do they work? 

Investors buy shares in a mutual fund, which represents a portion of the fund’s overall holdings.

The money from the sale of those shares is combined with the money from other investors to create a pool of capital. The mutual fund’s manager then uses that capital to purchase a diversified portfolio of stocks, bonds, or other securities based on the fund’s investment objective.

As the value of the fund’s underlying investments rises or falls, so does the value of each investor’s shares. Investors can buy or sell mutual fund shares at any time, and the fund’s net asset value (NAV) determines the trading price. We can calculate this by dividing the total value of the fund’s assets by the number of shares outstanding.

Types of mutual funds

Globally, there are thousands of mutual funds, each with its own strategy and investment objectives. It is possible, however, to group mutual funds according to the types of investments they make. Here are some of the most common types of mutual funds.

Stock funds

Stock funds invest primarily in shares, which financial experts consider a higher-risk investment. 

We can further classify stock funds into subcategories based on factors such as the size of the companies in the fund’s portfolio (large-cap, mid-cap, or small-cap); the sector focus (for example, technology, healthcare); or the geographic region of the investments (such as emerging markets, developed markets). 

Money market funds

These funds invest in short-term debt securities, such as treasury bills and commercial paper. The objective is to provide investors with a low-risk and low-return investment option. 

Money market funds are popular for investors who want to park their cash in a safe, liquid investment vehicle.

Bond funds

Bond funds invest primarily in fixed-income securities such as corporate bonds, government bonds, and other debt securities. 

Financial experts and investors generally consider bond funds lower-risk investments than equity funds, although they may offer lower potential returns. 

Balanced funds

Balanced funds invest in a mix of equities and bonds to achieve a balance of risk and return. The allocation between equities and bonds may vary based on the fund’s investment objective.

Index funds

These funds track the performance of a specific market index, such as the S&P 500 Index (SP: .INX) or the NASDAQ-100 Index (NASDAQ: NDX). Index funds aim to replicate the index’s performance by holding a portfolio of securities that mirrors the index’s composition.

Specialty funds

Specialty funds invest in a specific sector or industry, such as real estate, energy, or healthcare. These funds may offer higher potential returns than more diversified funds but also have higher risks.

Target-date funds

These funds are designed for investors who want a set-it-and-forget-it approach to investing. 

Target-date funds adjust the fund’s asset allocation over time to become more conservative as the target date approaches. This makes them a popular choice for retirement planning, as investors can choose a fund with a target date that matches their expected retirement date.

Active or passive: What’s the difference?

An actively managed mutual fund means the fund employs managers who select investments for the fund. Actively managed funds aim to beat the performance of a particular index, although there is no guarantee they will achieve this. 

Passively managed funds, on the other hand, simply track a benchmark index. There can be differences in the fees charged by active and passive mutual funds, so it is essential to understand how these will impact returns. 

Different mutual funds invest in different asset classes, whether actively or passively managed. Where a fund invests in shares, it may receive dividends, typically distributed to investors as dividend distributions.

There are many similarities between exchange-traded funds (ETFs) and mutual funds. The critical difference is that while ETFs trade on the stock exchange throughout the day, mutual funds can only be purchased or sold based on the NAV at the end of each trading day.

Which is the most popular among Australian investors?

Diversified equity funds are popular with Australian investors. These funds invest in various shares across different industries and sectors, providing exposure to the Australian stock market. 

Their popularity may be because Australian investors are attracted to the potential for higher returns that come with equity investments, although they also come with higher risks.

Australian investors also show interest in other types of mutual funds, such as fixed-income, international equity, and property funds. In addition, there has been a growing trend towards socially responsible and sustainable investing in Australia in recent years. As a result, ethical and sustainable mutual fund options are gaining popularity among Australian investors.

What are the pros of investing in mutual funds?

  • Diversification: One of the main advantages of mutual funds is that they provide investors with a diversified portfolio of assets, which can help to reduce risk.
  • Professional management: Experienced fund managers run mutual funds and have the expertise to make investment decisions on behalf of investors.
  • Accessibility: Mutual funds are a convenient way for investors to gain exposure to a range of assets without managing the investments themselves.
  • Liquidity: Investors can easily buy and sell mutual fund shares, making them a liquid investment option.

What are the cons?

  • Fees: Mutual funds charge management fees and other expenses, which can eat into returns over time.
  • Lack of control: Investors do not have direct control over the assets held by the mutual fund, and they cannot make investment decisions on behalf of the fund. 
  • Market risk: Mutual funds are subject to market risk, which means that the value of the fund’s assets can fluctuate based on market conditions.
  • Potential for underperformance: While professional fund managers have the expertise to make investment decisions, there is always the risk that the fund may underperform the market or its benchmark index.

Are mutual funds a good option for beginner investors?

Mutual funds can be a good option for beginner investors because they offer a simple and convenient way to invest in a diversified portfolio of stocks, bonds, or other assets. By pooling money from many investors, mutual funds can achieve a level of diversification that might not be possible for individual investors with limited funds.

Professional fund managers look after mutual funds making investment decisions on behalf of the fund’s investors. This can be helpful for beginner investors who may not have the time, knowledge, or expertise to manage their own investments.

However, beginner investors must do their research and due diligence before investing in a mutual fund. This includes understanding the fund’s investment objective, fees and expenses, past performance, and risks.

It’s also important to note that mutual funds are not risk-free investments and can still experience volatility and fluctuations in value. As with any investment, it’s important to have a long-term strategy and not make investment decisions based on short-term market fluctuations.

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a 'top share' is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a 'top share' by personal opinion.

As always, remember that when investing, the value of your investment may rise or fall, and your capital is at risk.

The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.