Contents
Mutual Fund Basics
Why Invest in Mutual Funds?
Mutual Fund Returns
Types of Mutual Funds
Mutual Fund Investment Holdings
Funds vs. ETFs, Stocks, and Bonds
How to Plan a Mutual Fund Portfolio
How to Research Mutual Funds
How to Buy Mutual Funds
|
 |
 |
 |
|
Funds vs. ETFs, Stocks, and Bonds
Before you begin buying mutual funds, it’s helpful to understand how they compare to other popular types of investments, such as ETFs, stocks, and bonds.
ETFs
Exchange-traded funds (ETFs) are the security type that is most similar to mutual funds. First created in the early 1990s, ETFs are index funds that trade like stocks. They offer the broad diversification of mutual funds with the instant liquidity of stocks: ETFs can be bought and sold throughout the trading day, unlike mutual funds. In addition, they often have low expense ratios, some of which are even lower than those of traditional index funds.
Why Buy Mutual Funds Instead of ETFs?
There are several considerations to take into account when deciding between mutual funds and ETFs:
- Cost: Transaction costs, also known as commissions, are fees investors pay every time they buy or sell a security. Though you can buy no-load mutual funds for free from most fund companies, you’ll pay a commission each time you buy or sell an ETF. If you’d like to buy your investments gradually, in stages, without paying commissions each time, mutual funds are likely a better choice than ETFs.
- Selection: Though ETF offerings are multiplying quickly, in some areas they don’t yet rival the selection offered by the thousands of mutual funds on the market. If you’re looking for a specific type of investment, your only choice may be a mutual fund.
- Flexibility: Like index funds, ETFs track the performance of a fixed selection of securities. As such, they lack the flexibility to respond to changes in the marketplace that affect the value of the particular securities they hold. Actively-managed mutual funds may be your best choice if you prefer to own investments that can adapt constantly as markets change. On the other hand, large mutual funds are often unable to effectively shift their holdings in response to changing market conditions. Mutual funds also sometimes have minimum holding periods, which penalize you for selling your fund shares until a certain amount of time has passed, ranging from six months to several years.
Individual Stocks
Though mutual funds make it very convenient and easy to own hundreds of individual stocks with just one investment, they require you to give up control of the specific stocks you own. There are two reasons why surrendering control of the individual stocks you own might lower your returns:
- Capital gains taxes: You’ll incur capital gains tax liabilities just from holding a mutual fund, even if you later sell the fund at a loss. The amount of capital gains tax liability you incur is up to your fund manager—not you—because he or she decides how much stock to sell and how often to sell it.
- Bad picks: Some mutual funds place a sizeable portion of their holdings in just a few stocks. If one of those stocks plummets in value, the fund will also. Conversely, if one of the fund’s stocks shoots up in value, you won’t have the freedom to sell it.
In addition, since stocks don’t charge investors expense ratios, you pay only the transaction costs required to buy and sell. That means if a stock increases in value by 10%, you’ll actually receive a 10% return on your investment, minus whatever commission costs you’ve incurred and taxes you owe on your profit.
Why Buy Stock Funds Instead of Individual Stocks?
There are several reasons why you may want to own stock funds instead of stocks:
- Diversification: A portfolio of several stock mutual funds, each of which holds a basket of many different stocks, is more diversified than a portfolio that contains only a few individual stocks. More diversification means less risk.
- Volatility: Volatility refers to the amount that an investment’s value tends to fluctuate investment’s value. Generally, individual stocks are much more volatile than mutual funds. If volatility makes you uneasy, mutual funds are a better choice than stocks.
- Cost: With certain exceptions, you can usually buy mutual funds without incurring any transaction costs. Each time you buy or sell a stock, you’ll pay commissions.
- Convenience: Mutual funds make it easy to build a balanced portfolio of investments with minimal time or effort. To build a balanced portfolio of individual stocks, you’d need to spend hours researching each stock before you buy and then monitoring your holdings on at least a weekly basis thereafter.
Individual Bonds
Individual bonds are a compelling investment for investors looking for a steady stream of income: you buy a bond with a certain interest rate and maturity, or duration, and you then receive that interest for the life of the bond. If you buy $1,000 of a bond with a 5% interest rate and a maturity of 10 years, you’ll receive $50 per year for ten years. The price of the bond can fluctuate until its date of maturity, but if you hold the bond until it matures, you’ll receive your original principal back in full. If you sell the bond before it matures, you may receive more or less than the price you originally paid and your interest payments will cease.
Why Buy Bond Funds Instead of Individual Bonds?
There are two main reasons to own bond funds instead of individual bonds:
- Diversification: Since bond funds usually hold many different bonds of a given type, you can diversify instantly by buying just a few funds, each of which specializes in a different type of bond.
- Convenience: By buying one bond fund, such as the Fidelity Total Bond Market Fund®, you can get instant access to a broad assortment of bonds in just one investment, complete with a yield roughly equal to the average yield of all the bonds in the fund. Using a bond fund is not only more convenient, but also less time consuming and expensive, than buying a portfolio of individual bonds.
| Acknowledgments & Disclaimer |
