Formally, a mutual fund is generally a type of professionally managed collective investment fund or vehicle, pooling the funds of many investors to purchase securities.
There is no legal definition of the term "mutual fund." It is most commonly used to describe collective investment vehicles that are regulated (by the SEC), and sold to the general public.
In the U.S. there are 3 types: open-end, unit investment trusts, and closed-end funds. Open-end is most common. This means that the fund has to be willing to buy back shares from investors every business day. Exchange-traded funds (or "ETFs" for short) are open-ended funds (or unit investment trusts) that trade on a stock exchange just like any other stock, e.g. Apple (AAPL).
Recently, ETFs have been gaining in popularity, mainly because of lower management fees. These fees are generally referred to as the Management Expense Ratio (or "MER") – i.e. the fees an investor would pay a fund manager to expertly manage the fund, regardless of the fund’s performance.
Investors pay the fund’s expenses, which reduces the fund's returns and/or performance. There is controversy about the level of these expenses because several mutual funds consistently under-perform the S&P 500, Dow or other indices, while collecting relatively high fees from the investors, regardless of fund's performance.
Mutual funds are generally classified by their principal investments. The four main categories of funds are money market funds, bond or fixed income funds, stock or equity funds, and hybrid funds.
I opened this post, leading off with the word “formally” for a specific reason: Informally, mutual funds and ETFs (albeit perhaps to a lesser degree), are the investment vehicles of choice utilized almost exclusively by the working, middle-class and/or less sophisticated investors.
Large diversification – which is common with mutual funds – does not protect investors from sharp declines in the market. A mutual fund that includes e.g. 20 companies is still in the market! Large downturns in the stock market, such as the ones experienced in 1999 or 2009, affect the whole market, including mutual funds... if every single stock in the fund goes down, the mutual fund goes down too.
Also keep in mind that a basic market rule is that downturns happen more sharply than upswings. This means you get slow upside growth and rapid downside losses.
Many working people contribute to a 401k or similar type retirement savings plan. These savings plans generally only allow employees to select one (or a basket) of mutual funds and/or bonds, as may be made available by the carrier (vendor providing the 401k plan administration services). Typically, investment return falls short of general market returns – as mentioned above – in addition to the investment being subject to (often high) fees.
Simple, common sense rules for smaller investors may be to:
- Invest in mutual funds in a 401k plan – to ensure that you save for your own retirement, and perhaps benefit from employer contributions, or better…
- Invest in ETFs instead of mutual funds – if available – because ETF fees are generally much lower than mutual fund MERs, or even better still…
- Create your own basket of stocks (e.g. copy a mutual fund prospectus, or Buffett’s equity holdings) and buy small quantities of these stocks on a regular basis (to benefit from cost averaging, as the market goes up and down). The reason why this may be deemed a better choice is because one can buy stock via an online brokerage account for minimal cost, with no further, future, downstream management fees.
Whatever choice you make, be sure to capitalize on your employer contribution – if available – because it’s free money. More importantly, make sure you save for your retirement because your government cannot be trusted to provide for you in the future, when you are ready to retire and/or perhaps no longer able to work.