How to Invest in Mutual Funds

If you want to understand how to pick the right mutual fund for you, you've come to the right place. In the guide below, I've put together all the major pieces of information you need to quickly evaluate and pick the mutual fund that best serves your investment objectives. Mutual funds come in a variety of shapes and sizes and with a variety of fees, so it's important that you get all the right information before deciding which fund is worth your investing dollars.

What is a mutual fund?

A mutual fund enables you to own a basket of individual stocks simply by owning one share of the mutual fund. Mutual funds are "actively managed," meaning that each one has a manager whose job is to pick stocks for inclusion in the fund and try to beat their benchmark (usually an index of some kind -- like the S&P 500 or the Russell 2000). In exchange for the instant diversification of a mutual fund and access to a (hopefully) market-beating strategy, you pay a management fee (known as an expense ratio).

Benefits of investing in mutual funds

Mutual funds have some advantages for individual investors.

  • Instant diversification. As I mentioned earlier, owning a share of a mutual fund means you own part of a variety of different companies. That helps hedge your portfolio and ensure you aren't too dependent on the success of any particular stock.
  • Time saved. If you're invested in a mutual fund, you don't necessarily have to track and research individual stocks -- after all, that's what you're paying the fund manager to do. For a new investor or someone without a lot of time to dedicate to investing, this is a big benefit. Generally speaking, if you don't have several hours per month to spend researching stocks, a fund of some kind (whether a mutual fund, an index fund, or an exchange-traded fund) is likely your best bet.
  • Potential outperformance. Mutual funds' managers aim to beat the market -- they want to prove to you that they're worth every penny of their management fee. Some mutual funds do indeed beat the market, allowing investors to reap the rewards of the fund managers' efforts.

Problems with investing in mutual funds

Of course, no investment vehicle is perfect. Mutual funds have their drawbacks, too.

  • High fees. Mutual funds tend to charge much higher fees than index funds or exchange-traded funds. We'll get more into fees in a little more detail further down, but consider that the average actively managed equity mutual fund's expense ratio is 0.78% of assets under management, while actively managed bond mutual funds charge an average of 0.55%, according to Investment Company Institute data from 2017. Equity index funds and bond index funds, by contrast, have respective expense ratios of 0.09% and 0.07%.
  • Historical underperformance. Over 90% of equity mutual funds have lost to their benchmarks over the past 15 years. (Bond funds did a little better, but the blended average is still 82% of actively managed funds losing to their benchmarks.) So most investors in most cases are paying more in fees compared to index lose to the market.
  • Tax inefficiency. Actively managed mutual funds buy and sell stocks quite frequently. Those sales -- as measured by fund turnover, i.e., the value of assets bought or sold in the past year as a percentage of the fund's total net asset value -- create taxable events, the same as when you sell a stock. Capital gains taxes can eat away at your investing gains. Actively managed funds pass those taxes on directly to investors, so unless you're investing in a tax-advantaged account, chances are good that you'll be paying extra taxes every year.

A guide to mutual fund fees

  • Expense ratio. The expense ratio is the annual fee a mutual fund charges an investor for the opportunity to park money in the fund. The expense ratio covers administrative costs and salaries for the fund's staff, and whatever is left over goes to the parent company as profits. The expense ratio is usually around 1% of assets under management or less. That may not sound like a lot, but imagine you invested $20,000 in an equity mutual fund that has an average expense ratio (0.78%) and earns a 7% annual return over 30 years. That $20,000 would grow to $120,370 -- a nice chunk of change! -- but in the meantime you'd be charged $13,587 in expenses. Further, every dollar you pay in expenses is a dollar that's not earning you 7% annually, so those expenses would cost you an extra $18,288 in opportunity cost. That's a total of $31,875 in returns lost to fees.
  • 12b-1 fee. This fee is usually part of the expense ratio, and it specifically represents money spent marketing the fund. It's not tied to fund returns or anything operational; it just helps the fund amass more money.
  • Front-end load. A front-end load is a sales charge on your initial investment in a mutual fund, which means it reduces how much money you actually put into the fund. Consider the example above: A front-end load of 2.5% would reduce your $20,000 initial investment to $19,500 (costing you $500 up front), and your final balance would drop to $117,361 because of sacrificed compound interest.
  • Back-end load. As you might have guessed, back-end loads are fees charged when you sell the mutual fund. Usually a mutual fund charges either a front-end load or a back-end load -- rarely both. So let's take the $20,000 example without a front-end load. If you sold at the end of that 30-year period, the back-end load would cost you an extra $3,009 in fees, reducing your holding to $117,361. That's exactly the same cost as the front-end load, because 2.5% of the total up front or 2.5% of the total at the end reduces your investing returns by the same amount.
  • Deferred load. A deferred load is a form of back-end load that charges you the equivalent of a front-end load. It's calculated when you make your initial investment but deferred until you sell the fund. So a 2.5% deferred load would cost you $500 on an initial $20,000 investment, even if that investment had since grown to $120,000. (And remember, you wouldn't pay until you sold the fund.) While all fees reduce investing returns, a deferred load is less damaging than other, similarly sized sales fees for this reason.

Other major mutual fund terms

As you're researching mutual funds, you'll regularly see the terms I'm defining below. Make sure you know them so you can find the right mutual fund for you.

  • Fund prospectus. A mutual fund's prospectus is filled with information you need to know before you invest in the fund. You can usually locate it online with only minimal effort, and it will help you pick the mutual fund that's right for your investment objectives. I personally tend to seek funds with great historical returns, low portfolio turnover (which I define below), and minimal fees. The prospectus also shares fund risks, which can give you valuable insight into the various ways your thesis can go wrong.
  • Assets under management (or AUM). AUM describes the total value of the fund in terms of how much money investors have plowed into the fund. This is important to know because, while a gargantuan fund isn't necessarily a great investment, some tiny funds are tiny for a reason -- namely, that they aren't great investments. A small AUM figure -- say, under $1 billion -- should typically be seen as a yellow flag and a signal that you should do more digging before you commit your money to a fund.
  • Inflows and outflows. Mutual funds make their money by charging fees based on their AUM, so they're incentivized to grow their AUM. That happens in two ways: Growing the underlying NAV of each share by picking winning stocks, and convincing more investors to invest in the fund. The latter is called a fund's "inflow." By contrast, a fund that is struggling or has lost investor confidence will have "outflows," or a net loss of capital (measured in dollars).
  • Portfolio turnover. Portfolio turnover is a measure of how frequently a fund buys and sells securities (usually stocks). The actual calculation is: The number of new stocks bought or sold (whichever is less; the numbers will generally be similar) divided by the fund's NAV over the past 12 months. It is expressed as a percentage, so a fund with a portfolio turnover of 75% replaced three-quarters of its investments over the past 12 months. Higher turnover means a larger tax bill at the end of the year, and it also means that the fund is generally holding securities for a shorter period of time. Here at The Motley Fool, we prefer funds with lower turnover, as it implies that the fund manager has a longer-term mindset (which leads to better fund performance over the long term).
  • Fund minimum. Many mutual funds require you to invest a minimum amount of money if you want to buy shares. If you invest less than that amount, there are often extra fees. Given how destructive mutual fund fees are to your returns, it's best not to buy into a fund unless you can reach the minimum.
  • No-load mutual fund. A no-load mutual fund doesn't carry any sales charges or commissions. That means fewer fees to eat away at your investing returns. Always seek no-load mutual funds, and if your financial advisor recommends one with a sales load, consider whether your advisor is really acting in your best interest.
  • Share classes. Many mutual funds offer several variations of the same fund, meaning that you have the option of purchasing different share classes (usually class A, B, C, or I shares). Look closely at the fee breakdown for each class before deciding which one to buy. The share classes do not denote any difference in investing philosophy or quality of stock-picking; the only difference is in their fees and who can buy them. "I" stands for "institutional," so that class is usually not available to everyday investors like you or me. FINRA, which regulates the brokers who sell mutual funds, has an excellent fund analyzing tool that you can use to better understand which class of the fund might be best for you.

How to invest in mutual funds the right way

Now that you understand the basics of how mutual funds work, let's turn to how to invest in mutual funds. You're in the investing game to make money, so let's talk about how you can invest in the best mutual funds to do just that.

  1. Decide your investment objective. What are you looking to achieve? Do you want to triple your investment, and are you comfortable taking on some risk to do so? Then you might consider a small-cap fund that uses the Russell 2000 as its benchmark. Are you looking to preserve capital and generate income? A bond fund may be your best bet. Are you looking for income and capital appreciation? A dividend stock-focused fund could make sense.
  1. Figure out your time horizon. The amount of time you want your money in the market matters: The longer it's there, the longer it can compound and help you better achieve your investing objectives. Here at The Motley Fool, we generally don't believe in investing money with a time horizon shorter than three years -- and most of us plan to measure our time in the market in decades, not months or years. The reason is simple: Markets go up and down, often sharply, over a matter of weeks, months, and years -- but across decades, there's a slow but fairly steady march up and to the right.
  1. Reduce fees (and avoid high fees). As the examples above have hopefully demonstrated to you, fees are one of the great killers of investing returns. If a mutual fund charges sales loads of any kind, you should run away. (Remember: No-load funds don't charge any of those fees.) Also avoid funds that charge much much more than the average expense ratio of 0.78% for equities funds. Here at The Motley Fool, our general rule of thumb is that you shouldn't pay more than 1% of your invested assets in fees each year. High expense ratios and sales loads violate that rule.
  1. Look up the fund's historical returns. The other great killer of investing returns is, well, picking bad investments that underperform. Fortunately, the mutual fund prospectus provides you with the fund's past performance relative to its benchmark. Has it underperformed over the past five, 10, and 15 years? If so, I'd pick another one of the hundreds of mutual funds with a similar investing objective. And if the fund has not been operating for at least five years, I'd be particularly leery. After all, historical performance helps you understand how the fund performs in both good times (like the bull market starting in 2009) and bad (the Great Recession). Given what is hopefully a long time horizon, you want a fund that has shown it can do well in both kinds of market. Consider also checking the returns net of fees and comparing those to the benchmark; that will help you understand whether the fund is outperforming even after extra expenses are accounted for. If it isn't, find another fund (and consider passively managed index funds as a possible alternative).
  1. Seek lower fund turnover. As I noted above, lower turnover implies that the fund manager has a longer-term focus, and it also reduces the tax inefficiency of the mutual fund. That's a win-win. Personally, I avoid funds with an annual turnover greater than 20%: Fund managers who try to time the market tend to underperform.
  1. Get to know the fund manager. An investment in an actively managed mutual fund is an investment in the fund manager. They have a past career, a past stock-picking track record, and a stated philosophy. Learn it all and make sure this is someone you want investing your money for you.
  1. Invest in the mutual fund. If you have found a mutual fund that checks all six of the boxes above, then you may have found the right one for you. The rest is fairly easy: If you have an online brokerage account, sign in and place an order for however much of the fund you wish to purchase. You will receive shares based on the mutual fund's closing price that day.

Keeping track of your mutual fund investment

Now that you've bought a mutual fund, you may assume that your research is finished. That's not quite the case. You should still check in on your fund quarterly to ensure that it's performing well. Keep in mind that even the best stock-pickers strike out from time to time, so one quarter's poor performance shouldn't necessarily spell the end of your relationship with this fund, but a trend of losing to its benchmark is another matter entirely.

Keep a spreadsheet of similar funds in the space and see how they're performing, too. That'll help you understand whether a fund's failure is because everything in the small-cap world is struggling (certainly possible) or whether that particular manager is to blame. And if someone else is strongly outperforming (and has a long history of doing so), consider running them through the due diligence checklist I shared above so you can consider opening a position with them, too.

But if you struggle to find a mutual fund that's outperforming its benchmark index after accounting for fees, it's time to consider whether an index fund or ETF is simply a better bet for your investing dollars. Sure, you won't beat the benchmark, but you'll at least perform right in line with it. And given the market's historical return of roughly 7% per year over the long term, that may well be good enough.

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