The role of mutual funds in an investment portfolio

Mutual funds play an important role in building a diversified investment portfolio. These funds invest in a wide range of assets to help reduce risk and offer broader market exposure for individual investors.

In this blog post, we’ll explore what mutual funds are, how they work, different types of mutual funds, their pros and cons, and how you can start investing in mutual funds today.

What is a mutual fund?

A mutual fund is an investment vehicle that pools money from many investors to build a diversified portfolio of stocks, bonds, or other securities. Instead of buying individual assets, investors buy shares in the fund and gain partial ownership of everything the fund holds.

How mutual funds work

When investors buy into a mutual fund, their money is combined and managed by a professional portfolio manager who decides which assets to buy or sell based on the fund’s goals. The fund’s performance depends on how well these assets perform – if stocks or bonds go up, so will the fund, and vice versa.

One of the main benefits of mutual funds is that they provide instant diversification, even with a small investment. Instead of an investor putting all their money into a single stock or bond, which can be risky, a single fund can hold hundreds of different securities across various industries and asset classes. Mutual fund investors also benefit from shared costs, professional expertise, and – if they choose – automatic reinvestment of dividends or capital gains.

Types of mutual funds

There are thousands of mutual funds in the U.S., but most of them fall into a few major categories:

Stock funds (equity funds)

These funds invest primarily in stocks and are typically used for long-term growth. Stock funds can be further categorised into:

• Large-, mid-, and small-cap funds based on company size
• Growth funds, which focus on companies with strong earnings potential
• Value funds, which invest in undervalued companies
• Blend funds, which combine growth and value strategies
• Dividend funds, which focus on income-generating stocks

Bond funds

Bond funds invest in debt securities like government bonds, corporate bonds, or municipal bonds. The goal is often to generate income that can be passed onto shareholders with limited risk. Bond funds can vary by:

• Bond type: High yield, investment-grade, or Treasury
• Maturity length: Short, intermediate, or long term
• Geographic focus: U.S., global, or emerging markets.

Index funds

Index funds aim to replicate the performance of a specific index, like the S&P 500 or Dow Jones Industrial Average. They follow a more passive strategy, which means they often come with lower fees compared to actively managed funds.

Balanced funds (asset-allocation funds)

These funds invest in a mix of stocks, bonds, and sometimes money market instruments. Their goal is to reduce risk through diversification and maintain a balance between growth and income.

Money market funds

Money market funds invest in short-term, high-quality debt instruments like Treasury bills. They’re designed to preserve capital and provide liquidity, however their returns are generally modest. In some cases, the returns on money market funds are only slightly more than those earned in a regular checking or savings account.

Income funds

These funds focus on generating regular income, usually through investing in government or high-quality corporate bonds. Income funds are commonly used by retirees or conservative investors seeking a steady cash flow.

International and global funds

International funds are those that invest in markets outside the investor’s home country. Global funds are mutual funds that invest both domestically and internationally. These funds provide access to international growth but may carry higher risk due to currency fluctuations or geopolitical events.

Sector and theme funds

Sector funds target specific industries like healthcare, energy, finance, or technology. Thematic funds invest based on trends or concepts that might span multiple sectors. For example, an artificial intelligence (AI) fund could have holdings in healthcare, defense, tech, and other sectors utilising AI.

Socially responsible mutual funds

These funds only invest in companies and sectors that meet specific criteria. For example, some socially responsible funds exclude certain industries (like weapons or tobacco) while others focus on companies promoting sustainability and ethical practices.

How to invest in mutual funds

If you’re ready to invest in mutual funds, here’s how you can get started:

1. Open an investment account

The first step is to open a brokerage account. Most online brokers allow you to invest in mutual funds with no account minimums.

2. Research and compare funds

Use your broker’s fund screener or research tool to find and compare mutual funds that align with your investment goals, risk tolerance, and minimum investment requirements. It’s also worth checking the fund’s strategy (e.g. passive or active) and performance history.

3. Understand the fees

Mutual funds charge management fees (called an expense ratio), so it’s important to compare fees before investing. Lower-cost funds can help maximise your long-term returns, however this should just be one aspect of a larger analysis when comparing between funds. In other words, don’t just go for a mutual fund with the lowest fees unless you’ve also considered the other factors above.

4. Make your investment

Once you’ve chosen a fund that aligns with your requirements, decide how much you want to invest and place your order through your brokerage account. Many platforms let you set up automatic investments so you can gradually build up your position over time.

5. Monitor and evaluate

Even though mutual funds are often long-term investments, it’s still smart to periodically review your fund’s performance and make adjustments if your goals or risk tolerance have changed.

Pros and cons of mutual fund investing

Mutual funds offer many benefits, but like any investment, they also come with certain drawbacks. Below, we compare the pros and cons of investing in mutual funds.

Pros of mutual fund investing

Diversification

Mutual funds spread your investment across a wide range of securities, providing faster and more cost-effective diversification compared to buying each security individually. This diversification can help reduce risk by offsetting losses in one asset by gains in another.

Easy access

Mutual funds are highly liquid and can be easily bought and sold through most brokerages. They also provide an accessible way for individual investors to participate in certain asset classes that might otherwise be hard to reach, like foreign equities or exotic commodities.

Economies of scale

Because mutual funds trade in large volumes, they pay lower transaction costs than what an individual investor would pay. They can also take larger positions than individual investors could, allowing them to benefit from economies of scale.

Professional management

Mutual funds are a relatively cost-effective way for individual investors to benefit from professional portfolio management.

Transparency

Mutual funds are regulated by the Securities and Exchange Commission (SEC) and required to disclose their holdings, performance, and fees on a regular basis. Investors can easily track what the fund owns and how it’s performing.

Cons of mutual fund investing

No FDIC guarantee

Mutual funds are not insured by the Federal Deposit Insurance Corporation (FDIC), and their value can fluctuate. This means there is a risk of loss, as is the case with many other investments.

Cash drag

To stay liquid and meet investor redemptions, mutual funds often allocate a large percentage of their portfolio to cash. This cash earns little to no return, which can slightly lower the fund’s overall performance.

Higher costs

Some mutual funds, especially those that are actively managed, charge relatively high fees. Expense ratios and sales loads can accumulate year by year and eat into returns over time.

Dilution

Dilution happens when a mutual fund becomes too large. In this situation, the manager can struggle to find enough quality investments to maintain the fund’s performance, which can dilute potential returns.

End-of-day trading only

Unlike stocks and ETFs, mutual funds can only be bought or sold at the fund’s net asset value (NAV), which is calculated at the end of each trading day. This limits flexibility.

Taxes

When a fund manager sells securities for a gain, the capital gains are passed onto shareholders – even though you didn’t personally sell anything. You can lower your tax liability by choosing tax-sensitive funds or holding mutual funds in tax-advantaged accounts, like a 401(k) or IRA.

Evaluating mutual funds

So, you’re ready to invest in mutual funds and you want to find the right one for you. Because mutual funds pool together many different securities, evaluating them can be a little complex. To make things a little more simple, here are some key factors to focus on:

Fund performance metrics

Past performance can help you understand how well a fund has managed in different market conditions. When evaluating a fund, look at its:

• Long-term returns (e.g. 3, 5, and 10 year performance)
• Volatility
• How it compares to its benchmark index.

Fees and expenses

A mutual fund’s fees can add up and impact your net returns. There are three types of fees to look out for:

• Operating expense ratio (OER): An annual fee that covers management, administration, and other fund expenses
• Load fees: Commissions charged when buying or selling fund shares
• Transaction fees: Some brokers charge a separate fee when buying or selling mutual fund shares.

Fund management

If you’re evaluating an actively managed fund, you may want to consider the fund manager’s experience, track record, and whether they’ve remained consistent with the fund’s stated strategy.

Mutual funds vs. other investment options

Mutual funds vs. index funds

Index funds are a type of mutual fund designed to replicate the performance of a specific market benchmark (e.g. S&P 500). Their goal is to minimise costs while mirroring the performance of that index.

In contrast, actively managed funds aim to outperform the market by choosing securities based on research and strategy.

Mutual funds vs. ETFs

Both mutual funds and ETFs offer access to diversified portfolios, but they differ in how they’re bought, sold, and managed.

The most important distinction is that ETFs are traded throughout the day while mutual funds are traded only once, after markets close. This means ETFs offer more liquidity, flexibility, and real-time pricing compared to mutual funds. As a result, they can be traded using the same strategies as stocks (e.g. short selling).

Example of a mutual fund

One of the most well-known mutual funds is the Vanguard 500 Index Fund (VFIAX), which tracks the S&P 500. The fund’s expense ratio is 0.04% and it has a minimum investment of $3,000 and an average annual return of ~8.27%.

VFIAX holds shares in major companies across all sectors, including tech, healthcare, consumer goods, and finance. Its top five holdings at the time of writing are:

• Apple (AAPL)
• Nvidia (NVDA)
• Microsoft Corporation (MSFT)
• Amazon.com, Inc. (AMZN)
• Meta Platforms, Inc. (META)

Because the fund passively mirrors the S&P 500, its holdings only change when the index itself is updated.

Disclaimer: FOREX.com Australia is a Contracts for Difference (CFD) issuer and our products are traded off exchange. We do not offer direct ownership of the product and exposure to mutual funds is available solely via Contracts for Difference (CFDs). This material relates to the underlying asset and does not constitute a recommendation or offer to trade.