Mutual funds are one of the most popular types of stock market investments. There are literally thousands of mutual funds available, each with its own investment objectives, fees, risks and benefits.
Mutual funds are simply groups of stocks, packaged together as a single investment by mutual fund managers and/or financial companies. The label "mutual fund" comes from the practice of pooling the money of many investors to buy a group of different stocks (sometimes hundreds or thousands of stocks) that would be unaffordable if an investor had to buy each stock himself.
Stocks can cost hundreds of dollars per share, so a single investor might need tens of thousands of dollars to own enough shares of enough different companies to maintain a proper asset allocation and diversification. By investing in a mutual fund, investors are essentially buying fractional shares and can therefore own the stocks of hundreds of companies, even with a small investment. Additionally, instead of tracking hundreds of stocks individually, an investor can keep track of a huge number of stocks by just watching a single mutual fund account.
The most important distinction among mutual funds is managed versus unmanaged. In the case of a managed fund, a fund manager decides (based on his own opinion and research) which stocks will make up the fund. If the fund manager makes good decisions, the fund may have high returns and outperform the market as a whole. However, if the manager chooses poorly, the fund will underperform. Also, managed funds often charge high fees in order to pay these managers, which can undercut returns.
Conversely, the stocks in an unmanaged fund are not chosen by a manager, but instead are assembled to mirror the makeup of a major market index, like the S&P 500. These funds are also known as "index" funds. Because an index fund simply tracks a specified sector of the market, it will never outperform or underperform that market sector. Due to the elimination of human input, index funds are considered less exciting than managed funds (no chance of fantastic returns in a year where the market was down) but also less risky (no chance of lackluster returns in a great market year). Index funds usually have lower fees and expenses than their managed counterparts, which helps to bolster returns.
Although all mutual funds are either managed or unmanaged, there are many other important classifications to consider when chooing a mutual fund investment. Mutual funds can contain stocks from any asset class or combination of asset classes, including large cap, small cap, growth, value, international, real estate and more. Some asset classes are riskier than others; some are more tax-efficient than others, so these variables should be weighed carefully. An investor can determine the underlying asset class of any mutual fund by looking at the stocks it contains.