What are mutual funds?

We've previously discussed some of the asset classes, such as stocks and bonds, that you can use to construct your portfolio, and there are many ways (or “vehicles,” in investment speak) to invest in these asset classes. Mutual funds are attractive investment vehicles for many investors.

Essentially, mutual funds are investment types that allow you to pool your money together with thousands of other investors (you don’t need to know them, of course) to purchase a collection of stocks, bonds, or other securities that might be difficult to create on your own. This is often referred to as a mutual fund’s portfolio. Mutual funds have stated objectives and can focus on individual asset classes, regions, or sectors or provide diversified asset allocation solutions.

Active vs. passive mutual funds

An important factor is whether or not a mutual fund is actively managed.

With actively managed mutual funds, the decisions to buy and sell securities within the fund’s portfolio are made by one or more portfolio managers in an attempt to meet certain objectives, such as improving performance, reducing risk, and generating income. An active mutual fund typically seeks to outperform its benchmark, which is generally some widely followed index, such as the S&P 500.

Passive mutual funds, often referred to as index funds, only track or follow the index, so they will often cost less for investors and move with their particular market or index. You’ll remember that most ETFs also track an index, rather than try to outperform it.

Keep in mind that there’s no guarantee that an active mutual fund will outperform (do better than) the index. It can just as easily underperform (do worse than) the index, not even including the additional fees that active mutual fund managers charge! Whether active funds are superior to passive funds, especially when considering their higher fees, is a lively area of debate in the investment industry.

Pros and cons of mutual funds

For many investors, mutual funds offer convenience and simplicity at a relatively low price. Rather than manage an entire portfolio yourself, you can easily buy a whole basket of stocks or bonds that will be professionally overseen.

However, mutual funds typically provide less flexibility in buying and selling shares than vehicles such as ETFs, because investors usually have to wait until the end of the day for transactions to occur. (The price of a mutual fund, also known as its net asset value, or NAV, is determined by the total value of the securities in the portfolio, divided by the number of the fund's outstanding shares. This price fluctuates based on the value of the securities held by the portfolio at the end of each business day.)

Investors in mutual funds also may have to pay additional fees or sales charges when they buy or sell funds, which can add to the expense of the investment. They also may be taxed on underlying gains and losses within the mutual fund, even if they did not buy or sell shares of the mutual fund itself. Thus, whether a mutual fund is "tax-efficient" (a tax-efficient investment limits your potential for taxes owed) is an important consideration for many investors.

Creating a well-diversified portfolio at a lower cost

Buying shares in a mutual fund is an easy way to help diversify your investments. Most mutual funds hold well over 100 securities. If you have a smaller sum to invest, building and managing a portfolio containing that many securities likely wouldn’t be possible. However, with just a few mutual funds, you can create a well-diversified portfolio at a lower cost.