Pooling your money with other investors may bring swimming results.
When you invest in a mutual fund, your money gets combined with the money of the fund’s other investors. A professional manager decides how to invest those assets based on the fund’s investment objective, what’s happening in the financial markets, and his or her investment style, or approach to choosing what to buy and when to sell.
An investment objective describes the financial results the fund aims to deliver. For example, one fund’s objective may be long-term price appreciation, or growth in value, while another fund may invest to produce a combination of current income and long-term growth.
Mutual funds come in three basic varieties: stock funds, bond funds, and money market funds.
Stock funds invest primarily in stocks, though the stocks they buy vary from fund to fund. Most stock funds invest primarily for growth, but some, called growth and income funds or equity income funds, invest for current income as well by buying dividend-paying stocks.
Since most stock funds invest in dozens of companies, they’re by nature diversified investments. Weak performances by some stocks that the fund owns may be offset by strong performances from others. That often makes the fund more price stable overall than individual stocks. However, if the stock market as a whole drops in value, the value of most funds invested in the market will drop as well.
Bond funds buy bonds. Investing in a bond fund provides current income, just as investing in individual bonds does. But you can invest smaller amounts and get greater diversification by buying shares in a fund. And you can automatically reinvest your income to buy more shares in the fund, something you can’t do with individual bonds.
But bond funds aren’t bonds. Your shares in a bond fund don’t mature at a particular time, they don’t earn a fixed rate of interest, and there’s no promise that you’ll get your original investment back. Instead, the value of bond fund shares goes up and down to reflect the changing values of its bonds in the secondary market.
Money market funds invest in short-term bonds and other debt investments, with the goal of maintaining a share price of $1 per share. These funds pay interest, usually at about the same rate as short-term CDs. But they’re not federally insured, and their value is not guaranteed.
A money market fund can work as a parking place for your investment account, as your emergency fund, and, with most funds, as a checking account, though there may be a minimum of $500 per check. But when interest rates are low, the fund may pay little or nothing.
A mutual fund’s value, or price per share, is based on the value of its underlying investments, which are the stocks or bonds it owns, and the number of shares investors own. To find the fund’s net asset value (NAV), or the market value of one share of the fund, you divide the total combined value of its underlying investments, minus fund expenses, by the number of existing shares.
Both the underlying value and the number of shares change all the time. So each fund computes its NAV at the end of every business day. You can find this information online.
If you buy shares in a fund directly from the investment company that offers the fund for sale, you usually don’t pay a sales commission, or load. If you buy through your financial adviser, your broker, or another intermediary, you generally do pay a load, either when you buy (in the case of Class A shares), or when you sell your shares (Class B shares), or every year you own the fund (Class C shares).
TWO WAYS TO GET PAID
Mutual funds pay out their profits to their shareholders each year. Income distributions are paid from the dividends or interest the fund earns on its investments. Capital gains distributions are paid from any profits the fund makes by selling investments it owns.
You can take these distributions in cash or you can reinvest them to buy more shares in the fund. Reinvesting is an easy way to buy more shares, and can help build the value of your account.
There is one catch: You owe some tax on your distributions every year even if you reinvest. The only exception is if you own the fund through a 401(k) plan, IRA, or another tax-deferred account.
EXCHANGE TRADED FUNDS
Another approach to pooled investing is buying shares of exchange traded funds (ETFs). Each ETF tracks a particular market index, such as the Standard & Poor’s 500 (S&P 500) and is listed on a stock market, where it trades throughout the day. The price moves up and down to reflect supply and demand, though it may not vary significantly from the fund’s NAV.
ETFs tend to cost less to own than actively managed stock and bond funds and even some index mutual funds, a cost that’s calculated as an expense ratio. But you may pay a commission to buy and sell, as you do when you trade stocks.
Another potential advantage is that you may have fewer short-term capital gains than you do with a mutual fund. One reason is that ETFs are not trying to beat the market, so their portfolios tend to change only when the underlying indexes change.
Some investors use ETFs to achieve greater diversification at lower cost than they could by buying individual investments, but, of course, ETFs can lose value in a flat or falling market.