Basics of Investing – Mutual Funds Explained

Investing Basics – Learn the basics of mutual funds, what the different characteristics mean, and in the end which mutual funds are best suited for your needs.

DISCLAIMER! – I will not be making any recommendations or stock picks, this is purely an educational post about investing. Please don’t consider this advice or consider any of the examples I use as me endorsing that company or fund.

Now to the meat: if, like most people, your career path did not entail learning the ins and outs of investing or the stock market, you probably would like to learn the basics. In a multi-part post, I will try to explain the basics to help you better understand your finances and your choices. In this section, I will try to cover the basics of mutual funds and by default exchange traded funds (ETFs), as those are primarily the options you will encounter in your basic 401(k) or IRA products. As a CFA charter holder and former Investment Analyst for an Institutional Investment Consulting firm, I routinely analyzed and evaluated mutual funds for multi-billion dollar client’s 401(k), Defined Benefit (Pensions) and Deferred Compensation plans.

What is a mutual fund? defines a mutual fund as “A mutual fund is an investment vehicle made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by money managers, who invest the fund’s capital and attempt to produce capital gains and income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.” So to break this down, many investors give money to a manager who then invests that money in the objective they have been hired to perform. For example, if the manager has a Large Cap Growth mandate (this will be explained in further detail later) they invest in a group of stocks that fit within this mandate. This manager then is supposed to follow a benchmark, with the goal to outperform the benchmark and their peer group. ETF’s are simply mutual funds that can be traded throughout the day, where mutual funds only trade at the end of the day. There are other differences but the important thing is that ETF’s have the ability to change prices throughout the day, where mutual funds only have an end of day price.

Asset Classes:

Mutual funds cover many different asset classes, asset classes are groups of securities that exhibit similar characteristics. The three main asset classes are equities (stocks), fixed income (bonds) and cash equivalents (money market instruments). Within each asset class are even more specific types of funds which I will discuss throughout this post.

Active Management vs Passive Management:

With active management, you are paying a premium for an opinion, the fund manager’s opinion. All mutual funds come with an expense ratio, this is how the manager makes their money. They receive a fee on the total dollar amount invested in their fund. Passively managed funds, try their best to mimic the performance of a benchmark or index. Since they do not have the ability to venture far from the index they are tracking, they do not charge as much for their opinion. For example, Vanguard 500 Index Fund Admiral Shares (VFIAX) has an expense ratio of 0.05% (Vanguard funds are known for having some of the lowest expense ratios in the business), their goal is to mimic the performance of the S&P 500 as closely as possible. On the other hand you have a fund like T. Rowe Price Blue Chip Growth (TRBCX) that has an expense ratio of 0.71%, this manager is trying to outperform the S&P 500 as well as the Large Growth Peer Group, and charges the investors a fee for their opinions. Written another way, active managers have teams of researchers looking at dozens of companies to pick the ones they think are best for you, while passive managers just try to track an index and keep their returns as close to the index as possible.

Current trends are favoring more passive management, it is tough to beat the market and rarely do managers beat their benchmark over long periods of time, not to mention the savings in expenses. My personal opinion coincides with this thinking, I would rather save money on expenses year in and year out rather than occasionally beat the market but pay more every year in fees.

Cash Equivalents / Money Market Funds:

I will not spend much time on these as they are fairly self-explanatory. These funds mimic cash holdings and are highly safe and highly liquid. They tend to have the lowest risk and thus lowest return of any asset class. Think of a savings account at your bank, minimal risk of declining value, but almost no return on your money.


Large Cap vs Mid Cap vs Small Cap:

What do these different Caps mean? Cap is short for capitalization, which is a fancy way of saying how large is the company and how risky is the investment. Large cap funds invest in the big names you hear every day, (Apple, Microsoft, GE, Ford…) these companies have market caps of over $10 billion dollars. Mid Cap companies range from $2 billion to $10 billion, examples are Electronic Arts, M&T Bank, and Western Digital. Small Cap companies are below $2 billion in market cap (micro cap and nano cap are the truly small companies but for this exercise think of small cap as any company under $2 billion), examples are Targa Resources, Advanced Micro Devices, and HD Supply. Now what do the different caps mean for investing? Think about market cap risk with investing as the risk the company you invest in going out of business, which company do you think is more likely to fold? Apple or Advanced Micro Devices (AMD)? AMD is more like to go bankrupt, but is also more likely to double in size. So on the equity risk spectrum, Large Cap mutual funds are the least risky, while small cap mutual funds are the most risky (but also have the most potential for larger returns). The chart below shows the calendar year returns of Large, Mid, and Small Cap Indexes for the past 10 years.


Value vs Growth:

What is the difference between value and growth focused equity mutual funds? Value based funds look to invest in companies that are trading below a fundamental level, they are trading at a discount and are considered a value for the price of the stock. Growth based funds are looking at stocks that are expected to grow faster than the market or their value counterparts. Value based funds also typically invest in companies that pay a higher dividend than their growth counterparts, they are returning money to investors more so than growth companies that are re-investing their cash to continue to grow. Value funds tend to be less risky and have lower price to earnings ratios, but similar to the market cap discussion, less risk means less opportunity for larger returns. Please see below the calendar year returns of Large Growth vs Large Value for the past 10 years.


International Funds?

Yes, other countries have stock markets, just like the U.S. does. Just about every country you can think of has at least 1 exchange that has different kinds of companies listed. Similar to what I have just covered, you can invest in International funds that have Large/Mid/Small cap focus, that are growth or value oriented, or are active or passive. Just know that international funds tend to have more risk and variability than U.S. funds, but greater opportunity for return. Emerging markets funds invest in countries that are just starting to become financially developed, these funds will have the most risk of losses and the most opportunity for returns.

Fixed Income:

What about Bond Mutual Funds?

Bond mutual funds are some of the most common funds that nobody really talks about, but they should! Bond funds invest in the debt (not the equity like stocks) of companies, countries, or pools of assets. There are many types of bonds out there, and equally as many type of bond mutual funds (similar to equity funds: active vs passive, domestic vs international), but I just want to talk about your basic features.

Duration (sometimes called maturity) is a common term when it comes to bond funds, and it has two definitions that really mean the same thing; one is how sensitive the bond is to changes in interest rates (bond prices and interest rates have an inverse relationship, when one goes up the other goes down), and the other is how long until the bond returns your investment. For example, say you pay $1,000 for a bond fund that has a duration of 5 years, you will receive your investment ($1,000) back in 5 years. Similarly, with a bond fund that has a duration of 5 (years) for every 1% increase in interest rates, the bond funds price would decrease by 5%, or a 1% decrease in interest rates would lead to the bond fund increasing in price by 5%. Longer duration usually means higher income from interest payments, but also more risk of price decline due to potential for increased interest rates. Nobody wants to be stuck with a 30 year bond with an interest rate of 3% when you can have a 30 year bond with 5% interest! So lower duration = lower risk.

Credit quality is another common feature of bond funds, nobody is completely risk free, but the U.S. government is the closest thing we have! Treasuries are the common term for debt that the U.S. government has issued, and they are “considered” to be risk free. Corporate bonds that have high credit quality are called investment grade bonds, and bonds that have low credit quality are called high-yield or “junk” bonds. The higher the credit quality the lower the return, less risk equals less reward. There are also special bond funds called Inflation-Protected bonds, these are funds that invest in bonds that are backed by the U.S. government and whose principal is adjusted quarterly based on inflation. These are a great resource if you are worried about inflation (the price of normal goods increasing).

Balanced and Target Date funds:

Balanced funds are mutual funds that invest in both stocks and bonds in a predetermined mix. A great example is the Vanguard Wellington Fund Investor Shares (VWELX), it is made up of 54% US stocks, 10% international stocks, 33% bonds and 3% cash/other. These funds are great investment vehicles if you want different exposures without having to purchase multiple funds to get the same mix. One of the best innovations in recent years in the mutual fund world are Target Date funds. These funds are based off the year you retire, for example, the Vanguard Target Retirement 2055 Fund (VFFVX) is managed to have the optimal asset allocation for someone that will retire around 2055. The main difference between a balanced fund and a target date fund, is that the target date fund changes its weights over time (called a glide path). The closer the fund gets to its target retirement date, the less risky it becomes by reducing the exposure to the riskier investments over time, and increasing the exposure to the less risky more income producing investments at the same time. If you do not want to manage your investments and just want to set it and forget it, target date funds may be a great option for you. One last thing to also keep in mind, some Target Date funds manage the money “to” your retirement, while others manage “through” your retirement. The key difference between them is the “to” fund stops changing allocations once retirement is reached, while the “through” fund will continue to change the allocations past the point of retirement.

Alternative / Specialty Asset Classes:

There are many specialty and alternative asset classes out there (natural resources, gold, real estate…) but these are riskier investments that have specific fundamental qualities. Make sure you do plenty of research before investing in any of these types of funds, don’t just chase higher returns.


When evaluating a mutual fund, the two main characteristics are risk and return. Return is the amount of money you receive from your investment, in either price increases or income (both dividend for equities and interest for bonds). This is fairly easy to understand, you invest $1,000 and the total return you received after that year is 10%, your account now has $1,100 dollars. Risk is a much trickier subject, but probably more important than return. Risk, usually measured as Standard Deviation, is how much the returns can deviate from the mean (average) return. Standard Deviation is a statistical measure of the square root of variation of data points from the mean. Without going into too much detail, Standard Deviation shows how volatile a fund or asset class can be, if the average return of an asset class is 10% and has a historical standard deviation of 15%, this means that 68% of all returns fall between a high of 25% return and a low of -5% return. If nothing else Standard Deviation will allow you to compare the risk of two different asset classes, just remember the higher the Standard Deviation, the more volatile (higher highs and lower lows) the fund.


Mutual funds can accomplish anything you want, provide an all-in-one solution (target date fund) to allow you to target a very specific exposure (precious metals miners). In the end what you need to understand is that risk and return go hand in hand, the more return you want, the more risk you need to be willing to take. I have listed below the asset classes, sorting from least risky to most risky, but like every mutual fund company ever has said, “Past performance is not indicative of future results!”

  1. Money Market Funds
  2. Fixed Income
    1. Shorter Duration, Higher Quality, Domestic = Less Risky
    2. Longer Duration, Lower Quality, International = More Risky
  3. Equities
    1. Large Cap, Value, Domestic = Less Risky
    2. Small Cap, Growth, International = More Risky

My next post will try and help you answer the obvious follow up question, How do you decide how much risk is right for you?

Stay tuned, more Modern Finance is coming your way!

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3 Responses to Basics of Investing – Mutual Funds Explained

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