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How Do Mutual Funds Work?

Mutual funds may be a solid investment tool for your retirement, but understanding how they work can be complicated. Why all the different types? What about fees—how much is too much? How do you know when it’s time to drop a fund?

And why does this stuff have to be so confusing?

We understand your frustration. The good news is that, with a little knowledge, you can go from confused to confident when it comes to mutual funds. Let’s get started.

How to Pick a Mutual Fund

First, let’s talk about which fund types you should invest in. Out of the nearly 10,000 mutual funds out there, how do you know which mutual funds to pick? We recommend splitting your investment evenly across four different types of mutual funds—growth and income, growth, aggressive growth, and international—in a tax-advantaged savings account like a 401(k) or an IRA. Here’s a quick explanation of each:

  • Growth and Income: Also called large-cap, these funds are generally from companies that are well established and have a value of over $10 billion. Because they typically have a long history of solid performance in the market, many consider these a low-risk investment that’s a solid foundation for your portfolio.
  • Growth: Growth funds are made up of funds from medium to large companies that are—you guessed it—growing. They go up and down with the economy’s ebb and flow more than growth and income funds, but they can yield higher returns.
  • Aggressive Growth: These funds are made up of smaller companies with lots of growth potential. Because they can fluctuate wildly, they are often considered the "wild child" of your fund portfolio. Aggressive growth funds have the highest risk, but they also hold the potential to pay off with a much higher return.
  • International: International funds allow you to invest in foreign-owned companies you already do business with, like Trader Joe’s or Gerber.

Within each of these groups you’ll need to pick which mutual funds you want to invest in. The four main factors to look at when choosing a mutual fund are:

Track Record

When deciding what fund is the best fit for you, don’t be tempted to let its recent success (or failure) color your thinking. Look at the fund’s long-term track record, preferably the last 10 years or more. Is it consistently outperforming other similar funds, or is it continually lagging behind?

Volatility

Volatility is a measure of how much the fund’s value fluctuated over the past year. Every mutual fund has some level of volatility as values rise and fall with the stock market. But how much is too much? That depends on you and your tolerance for risk.

Costs

To figure out what a fund costs, you’ll want to look at its expense ratio. That’s the percentage of your investment you’ll pay each year to own the fund. You’ll also want to look at sales charges, transaction fees and brokerage charges. Depending on the class of fund you choose these costs may vary. More on that later.

Diversification

One of the substantial benefits of mutual funds is their built-in diversification. One mutual fund can spread your investment across many different types of companies. That allows you to use the power of the stock market to build your savings without taking on the risk of single-stock investing (which is always a bad idea).

Types of Mutual Fund Fees

Though you should never decide on a mutual fund based on fees alone, it’s important to understand the long-term impact of a fund’s fees and expenses. A small difference in fees can make a huge difference in your returns down the road.

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There are two types of fees associated with mutual funds: ongoing fees and transaction fees. Under the "shareholder fees" section of the fund’s prospectus, you’ll find both the ongoing fees—which are included in the fund’s expense ratio (cost to operate the fund)—and the transaction fees.

Here’s a breakdown of what’s included in each:

  • Management Fee: Also known as an asset-based fee, this fee is what you pay to the fund manager or the team of investing professionals who make sure the fund achieves its investing objective and performs well. Typically, this fee falls between 0.5% and 2% of the assets being managed.
  • 12b-1 Fees: These fees pay for the marketing and selling of the fund. These are capped at 1% of the fund’s assets and are paid directly out of the fund.
  • Miscellaneous: These include accounting fees, audit fees, as well as recordkeeping and legal fees.
  • Transaction Fees: These include redemption fees, sales charges and trading fees.

We know that’s a lot to remember, and it can get confusing. That’s one of the reasons I recommend working with an investing advisor. These pros can explain the details and your options in easy-to-understand language.

How Mutual Funds Pay

If you own a mutual fund, you’re considered a shareholder. You can make a profit from your investments in one of two ways: through dividends or capital gains.

Dividends

Dividends are a reward to sharefholders for holding onto certain stocks or mutual funds for the long term. Keep in mind, not all stocks offer dividends, and there are several different types. In most cases, dividends are paid quarterly and in cash. You can either pocket the money or re-invest and buy more shares.

Capital Gains

This money is paid out when your investment is sold for a higher price than what you originally paid for it. (That’s why you hear the phrase, "buy low, sell high.") But you don’t get that money until you sell your shares. Your profit is merely on paper—not in your pocket.

Just think of it this way: Dividends are paid at least yearly (but often quarterly), while capital gains are paid out when you sell the investment (if you earned a profit).

When You Should Drop a Fund

If a fund doesn’t perform well over the long haul, or if it’s not a good fit for your overall strategy, it may be time to drop that fund from your investing portfolio. Here are some of the things we look at when deciding whether to drop a mutual fund. As always, it’s best to reach this decision with your financial advisor.

The expense ratio is too high.

Though you should never choose a mutual fund based on its expense ratio alone, understanding a fund’s expenses is important. Every penny you pay toward expenses and fees is money that’s not in your investment—and it’s not moving you closer to your retirement goals.

There’s too much turnover.

When a fund has a high turnover rate (the percentage of the fund’s holdings that are bought and sold each year) it can lead to significant fees and potentially costly tax implications for funds outside of a retirement account. It also shows that the management team might be trying to time the market for a bigger return.

Your portfolio is out of balance.

Over time, as the market fluctuates and shares are bought and sold, your portfolio is bound to change. This may mean you no longer have 25% of your investment in each of the four categories. To get back on track with your strategy, your investment professional can rebalance your funds. This typically happens a minimum of once a year. Remember, balance is the key.

Mutual Funds as Part of Your Long-Term Strategy

With sacrifice, hard work and some old-fashioned patience, you can make the most of your investing journey. But it won’t happen overnight. Mutual funds are designed to be long-term investments. So when things get rocky, stick to your plan. Retirement investing is a marathon, not a sprint.

Your financial future is up to you. Protect yourself and your finances by being an informed investor. If you need help, work with an experienced investment professional who can help you understand where your money is going. Your money and your future are too important to leave to chance.

Find your SmartVestor Pro today!

 

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners.

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