Investment funds could help you build a well-rounded portfolio. Here’s a breakdown of how investment funds work, including their pros and cons, and a step-by-step guide to how you can invest in investment funds.
What are investment funds?
Investment funds are collections of assets an investor can purchase by placing a single trade, allowing the investor to get exposure to all the assets without buying them individually. Investment funds have become an investing staple because investors might not otherwise be able to afford the assets in these funds or easily recreate the mix of fund investments on their own. That’s because, for instance, a bond fund might invest in thousands of different bonds or an index stock fund might contain hundreds of different stocks.
How do investment funds work?
When you buy an investment fund, your dollars are often combined with other investors’ money. That’s then used to buy different assets according to the fund’s objective and strategy—say, replicating an index or trying to outperform one. Fund managers select the investments and track their performance over time, deciding which assets to add to and subtract from the fund.
If you invest in a fund, you don’t directly own the underlying securities. Instead, you own shares of the fund itself. The value of those shares moves up and down based on the total performance of all assets within the fund and whether other investors are buying or selling their shares in the fund. For the convenience of having someone else buy and adjust the makeup of the fund, funds often charge a fee called an expense ratio. You pay that fee as a percent of your total dollar value invested in the fund. How high that percentage is depends on whether the fund is actively or passively managed.
Actively managed funds
These typically aim to outperform a benchmark, like a popular stock or bond index. A team of financial professionals does extensive research to choose the funds’ investments and thus build a portfolio aligned to the fund’s objective. For this added expertise, actively managed funds typically charge higher fees than passively managed funds.
Passively managed funds
These typically try to replicate the performance of a benchmark, section of the market, or price of a commodity. Although financial professionals aren’t hand-picking investments in passive funds like with active funds, fund managers still play a crucial role in balancing the fund to help ensure the fund’s performance accurately tracks the intended benchmark.
In addition to being passively or actively managed, investment funds can be classified as closed-end or open-end.
Closed-end funds
Closed-end funds are different than traditional mutual funds and ETFs. Instead of issuing shares based on money invested into the fund, closed-end funds have a set number of outstanding shares, and the price of those shares fluctuate as investors buy and sell shares, similar to a stock. Typically, closed-end funds hold illiquid securities (like emerging-market stocks and municipal bonds, which help cover local government projects). These may have a higher potential for returns but come with greater risk.
Open-end funds
An open-end fund is a type of investment fund where shares can be issued and redeemed at any time. Most mutual funds and ETFs are open-end funds. Investors can buy shares of open-end funds directly from the fund provider or from a brokerage like Fidelity. Typically, the price of an open-end fund’s shares is determined by the total value of the assets of the fund, minus any fund expenses, divided by the number of shares, aka the fund’s net asset value (NAV). However, open-end funds sold on exchanges, like some ETFs, can be traded above or below the fund’s NAV depending on their current market price.
Types of investment funds
There are a handful of investment fund types that differ from each other on factors such as tax rules and objectives.
Mutual funds
Mutual funds pool money from investors to buy a portfolio of different stocks, bonds, and/or other investments. Often managed by a team of financial pros, mutual funds range in strategies, from conservative bond portfolios to high-risk growth stock funds. Mutual funds trade and are priced only once, at the end of the trading day.
Whenever a mutual fund company passes earnings and other payouts to shareholders, it’s known as a distribution. If you hold shares in a taxable account, you are required to pay taxes on mutual fund distributions, whether the distributions are paid in cash or reinvested in additional shares.
ETFs
Exchange-traded funds (ETFs), similar to mutual funds, pool money from investors to buy a basket of different investments under a specific objective and strategy. However, unlike mutual funds, ETFs trade on exchanges like stocks, where you can see real-time price movement during the trading day. Also unlike mutual funds, managers selling assets in the fund don’t typically expose the investor to taxable capital gains.
Index funds
Index funds can be either mutual funds or ETFs, but typically they’re passively managed. They aim to mirror the performance of a market index, like the S&P 500® or Nasdaq. Some index funds track the performance of investments in the US or international markets, while others aim to track certain industries or companies.
Target date funds
Target date funds invest your money depending on a specific year when you plan to withdraw those dollars. These types of strategies adjust the fund’s investment mix over time to balance growth potential with risk management. As you near the target year, the assets held by the fund become more conservative.
Money market funds
Money market funds invest in short-term and high-quality debt instruments, like Treasury bills and commercial paper, which corporations and federal or municipal agencies issue to cover short-term obligations. The returns on money market funds1 are generally not as high as those of other types of fixed income funds, such as bond funds, but they do seek to provide stability. Some investors use money market funds as the core position to process cash transactions and holding uninvested cash in their brokerage accounts, or to park cash for short-term goals or for their emergency savings, or even as a low-volatility position in their investing portfolios.
Advantages of investment funds
Here are 3 potential reasons why investment funds have become a popular option for investors:
- Diversification: Many investment funds invest in hundreds if not thousands of different assets. That diversification spreads your money across many investments, which can help to reduce the impact of a single underperformer.
- Professional management: A team of financial professionals control actively managed funds and aim to outperform market benchmarks, placing your dollars in potentially lucrative positions—though there are no guarantees your investment will make gains.
- Accessibility: Investment funds can expose you to investments you otherwise wouldn’t be able to afford or a collection of assets that would be difficult to recreate by yourself in your own portfolio. For example, a bond fund may invest in a bond that has a $10,000 minimum, or an index fund may be made up of hundreds of stocks you can access with a single share.
Disadvantages of investment funds
Here are 3 potential downsides to consider:
- Fees and expenses: To cover administrative costs, investment funds charge expense ratios that could eat into your overall returns.
- Risk: As with any investment, you could lose all the money you invested. Plus, passively managed funds carry a small risk of inaccurately tracking their benchmark, and actively managed funds may not outperform the general market.
- Lack of control: Although investment funds give you the benefit of professional management, that means you’re not in the driver’s seat. You have less control over where your dollars are invested with an investment fund than you would by creating your own portfolio.
How to pick an investment fund
Choosing the right investment fund for your financial goals comes down to several key factors.
1. Determine your risk tolerance
Your risk tolerance is how comfortable you are with potentially losing the money you invested. Decide how much risk makes sense to take on to help reach your financial goal. In general, the thinking is that longer timeframes mean you could wait out inevitable market bumps and downturns. But ultimately, it’s a personal decision related to your comfort level and past performance doesn’t guarantee future returns.
2. Consider funds representing a mix of different asset classes
Different assets typically have different risk levels. With your risk tolerance in mind, decide what types of funds you’ll research. For example, a diversified portfolio often has exposure to stocks, bonds, and other investments.
3. Explore active vs. passive management
Consider whether you want to invest in funds that are actively or passively managed, or a mix of both. While actively managed funds have the potential to outperform benchmarks, they often come with higher fees and of course, the fund might underperform the benchmark as well.
4. Research funds’ ratings
It could be helpful to pick out a handful of fund options and compare their ratings, which third-party firms usually publicly provide.
5. Assess expense ratios and other fees
Determine whether the fund’s return potential may be worth the fees it charges before you invest, though, again, keeping in mind that past performance doesn’t guarantee future results.
How to invest in investment funds
Here’s a step-by-step guide to adding investment funds to your portfolio.
1. Define your investment goals
Are you building emergency savings, investing for retirement, saving for education, or something else? Determine what you’re investing for, how much you’re aiming to amass, and by when.
2. Research fund options
Using the steps detailed above, narrow down fund options.
3. Choose a brokerage firm and account
Select a brokerage firm that offers access to the funds you’re interested in. Consider whether there are investment minimums and user-friendly tools. Then choose the account type that best aligns with your goals.
4. Fund your account
Deposit money into your investing account so you can place your trade.
5. Purchase shares
Decide how much to invest upfront, then buy shares of your selected funds. You could invest all your dollars immediately or buy small equal increments over a set period, using a strategy called dollar-cost averaging.
6. Monitor and adjust
Regularly check in on your investments, at least once a year, and rebalance your portfolio over time so it tracks to your investment goals.