If you’re looking for diversification in your portfolio, mutual funds can help you toward your goals. But the array of choices can be dizzying.
Looking to pursue a diversified portfolio, but you’re crunched for time? Or maybe you have little investment experience and you aren’t quite sure how to diversify a portfolio. Investing in mutual funds might be one possibility. Because mutual funds are generally run by professional investment managers, they offer a way for new investors to get that first market exposure.
But deciding where to invest can be a daunting process. What’s your objective? Should you take an aggressive approach, or is a Goldilocks tactic more suitable for your time frame and risk tolerance? Should you consider investing in actively managed funds or those that are passively managed, such as funds that track an index or other benchmark? And finally, how might your tax situation affect your selection?
Before we get ahead of ourselves, let’s take a look at the basics.
As the moniker implies, a mutual fund is an investment vehicle that pools the funds of many investors and invests those funds in stocks, bonds, or other assets, as specified by its prospectus—a document that describes the fund’s rules, objectives, limitations, and other information.
A fund’s investors may range from individual investors’ 401(k) plans and Individual Retirement Accounts (IRAs) to institutions such as pensions and university endowments.
Mutual fund returns come from capital gains and income from the underlying securities of the funds, which are typically stocks and their dividends, bonds and the interest paid on them, and other assets.
Unlike individual stocks, whose prices fluctuate throughout the trading day and can be bought and sold whenever the market is open, mutual funds are priced and settled once a day to what’s called a net asset value (NAV). A fund’s NAV is the per-share market value of all the securities held by the fund, less any of the fund’s liabilities. Anytime an investor deposits money into the fund or redeems shares from the fund, the transactions are included in the day’s NAV.
Capital gains on fund assets are typically passed on to investors through taxable distributions, generally on an annual basis. If the securities are not sold, a mutual fund typically nets out all the gains and losses on securities bought and sold, then distributes what’s left to fund shareholders on a per-share basis. An investor can choose to take the capital gain or reinvest it in the fund. Keep in mind mutual funds don’t pay taxes; the tax obligations are passed on to shareholders.
Suppose you’ve got $10,000 to invest, and you’d like to spread it across 100 or more big-name companies. If you were to invest in individual stocks, your money wouldn’t take you too far into variety, right?
But if you were to invest your $10,000 in a large-cap fund, for example, you’d get exposure to all of its securities, all wrapped up in one product. In this way, a mutual fund can be a diversified investment in and of itself.
Most investment professionals would agree that a diversified portfolio—spreading your financial eggs across multiple baskets—can reduce the risks of investing in a particular stock, industry or even sector. But it’s important to note that equity mutual funds and other forms of stock diversification won’t protect a portfolio from the ebbs and flows of the broader market (aka “market risk” or “systemic risk”).
There are a couple of points worth noting here. First, although investing in a mutual fund gives you exposure to the return profile of its securities, you don’t hold shares of those securities, so any associated voting rights are retained by the fund, not you.
Plus, if you’re interested in adjusting your risk profile, you can’t really change the allocations within an individual fund. The fund manager’s concern is maximizing return while managing risk, as well as keeping within the fund’s objectives, rather than considering the portfolio needs of individual fund investors. So if a fund isn’t meeting your objectives, your only option is to redeem your shares.
When investors first invest in a mutual fund they hopefully examine the prospectus and know the fund's objectives and major holdings, but as investors hold the fund over years, it's possible for the fund to change. Sometimes the underlying ideas of what types of securities the fund holds and its risk tolerance change over time. This "drift" can mean that fund investors may not own what they thought they owned.
Mutual funds come in a dizzying variety of offerings—stocks, bonds, money markets—covering an array of sectors, subsectors, and industries. They can target companies based on market capitalization, dividend history, corporate governance, and more. Mutual funds can even target foreign-based securities. Some mutual funds target the performance of broad-based indices by holding the underlying securities in a proportion that mirrors the index composition, which offers another way to pursue a diversified portfolio.
When you're looking to select a mutual fund, how might you go about paring the list of choices down to a manageable length? TD Ameritrade clients can use screeners on the website that offer dozens of criteria. You can screen funds by type, performance, ratings, fee structures, and more. Want to limit your search to include only socially responsible funds? Screeners can help you do that, too. See figure 1.
By pooling funds with thousands of other investors, mutual funds can help you pursue a diversified portfolio that aims to spread risk across a wide variety of investments and help shield your assets from the risks of being heavily concentrated in a few stocks, even if you're still exposed to regular market ebbs and flows. But investing in mutual funds isn’t foolproof; as with any investment, there are never any guarantees of profits or prevention of losses.
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