What Is a Mutual Fund?

Source: Seniorliving.org.

If you have a retirement plan at work, such as a 401(k) or similar, then you almost certainly own shares in mutual funds. But what is a mutual fund?

In short, it's a great way to invest, without requiring large sums of money, or a lot of research into individual stocks, bonds, or particular industries, since your money is pooled with that of many other investors, and then invested by the managers of the mutual fund.

But there's more to know that just that. In this article, we'll take a deeper look at mutual funds, focusing specifically on the things you need to know to pick the best ones for your needs, as well as to avoid common pitfalls that will end up costing you a lot of money over time.

Mutual funds explainedIdeally, mutual funds should be a low-cost and simple way for individuals to invest and save for retirement and other long-term goals, but with more than 7,000 funds out there it can get overwhelming. There are funds that focus on specific industries such as energy or consumer goods, funds that invest based on a particular strategy, such as growth stocks or big dividends, funds that invest in international companies or specific geographical regions, funds that invest in bonds instead of stocks, and funds that invest in a mix of both.

There are two overlying strategies that fund managers can take: Either actively managed by a team of stock pickers, or passive funds that simply track to the performance of a major benchmark such as theS&P 500.

The bottom line is this: Active funds are designed to meet a specific strategy, such as capital growth, income generation, or capital preservation, as examples, while passive index funds will simply mimic the performance of the benchmark. In other words, part of picking the right mutual funds requires that you identify what you're goals are, both in the short and long term.

How a mutual fund worksIn essence, a mutual fund pools all of the money of the investors in the fund and invests it together. By owning a piece of the fund, you hold partial ownership in all of the assets the fund holds. This makes mutual funds a great way to diversify risk without having to own lots of individual stocks, as long as the fund itself is diversified.

Here's the catch: Investing in a mutual fund isn't free. The fund has expenses, such as the salaries of the analysts, costs to market the fund, and profits the companies that run the funds expect to collect. Those costs are measured in a number called the expense ratio.

The expense ratio is largely a catch-all number that shows the percentage each year that the fund manager takes from assets to cover the costs described above. The expense ratio you pay for a mutual fund can range from as much as 2% for actively managed funds, to extremely cheap 0.05% (that's right -- five hundredths of one percent) for the largest passive index funds.

Historically, most mutual funds have been of the actively managed variety, with the idea that a team of seasoned financial experts should be able to outperform most market indices, as well as better navigate downturns, thus reducing losses in the short-term.

This better performance should come at a higher cost, right? Unfortunately, the data paints a different picture.

Active versus passive mutual fundsWhile the theory that professional mutual fund managers should be able to regularly outperform the market sounds great, history has shown that to rarely be the case. According to S&P Dow Jones Indices SPIVA, a biannual report that measures the average performance of actively managed mutual funds against their benchmarks, the vast majority of funds underperform.

According to the most recent SPIVA scorecard, more than 86% of large-cap fund managers underperformed the S&P 500 in 2014. Looking at longer-term results, the performance remains just as dismal, with 89% and 82% of active funds underperforming the index over the past five- and 10-year periods, respectively. Without boring you with more details, this trend of active fund underperformance extends across every fund category measured, not just large-cap funds.

In other words, the vast majority of investors would have gained better returns over the past decade, simply investing in a low-cost index fund, versus more expensive active mutual funds that tend to underperform.

The real cost of fees and underperforming fundsOn the surface, it may seem as if the difference in a 1% fee and a 0.1% fee isn't a lot of money, but it's amazing how much it adds up.

According to S&P Indices latest SPIVA Scorecard, the S&P 500 has averaged 7.67% in annual returns over the past decade. The average large-cap mutual fund averaged 6.81% in after-fees annual returns over the same period. If we extrapolate that over 30 years of saving, it really adds up:

Based on 2014 SPIVA 10-year S&P 500 and large-cap fund returns data. Chart by author.

The average underperformance wouldcost nearly $68,000 in returns -- that's almost two years' retirement income for the median retired couple -- for someone investing $5,000 per year over 30 years. If the fund underperforms by more than the average, which isn't unusual, the gap gets even wider.

Final thoughts: Know how much you're paying. Understand your needs.Historically speaking, very few actively managed mutual funds have been able to sustainably outperform the market. Because of this clear data, long-term investors are probably best off investing in lower-cost passive index funds.

The bottom line is this: Notallactively managed funds are bad performers, but the vast majority have generated less returns for investors than index funds would have. At the end of the day, choose the mutual fund that gives you the best chance of adequate returns, with the least amount of cost, based on the choices available to you, and your short- and long-term investing goals.

The article What Is a Mutual Fund? originally appeared on Fool.com.

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