A mutual fund is basically an amount of money that is “mutually funded” by a large amount of people. This money is managed by fund managers who require a percentage fee for their labor. The managers invest in securities and as the value of the investments rise or fall, so the equity of the shareholders in the fund rise and fall.
So if you purchased one $1 share of a $100 fund then you own 1% of the overall value of the fund. If the management’s investments of the fund raise the value to $110 then you just made 10% and your share is now worth $1.10.
This is a very simple overview. Clearly the details are much more complex. For example the management fees, taxes and dividends change the return dynamic. But in terms of understanding the basics of mutuals funds, this does the job.
1. Active Mutual Funds
An active mutual fund is one in which the manger(s) work to select the best security investments they think will produce the best returns. They usually charge a higher management fee because of the perceived value and expertise they provide.
2. Index Funds
The alternative is to have a fund set up in a way that involves very little research and work on the part of the management. “But why wouldn’t you want to take of advantage of the manager’s expertise?” you might ask. The answer comes down to two variables: Cost and performance.
Not only do active mangers usually charge higher fees (cost) but they often don’t actually invest in a way that outperforms the market(performance). So the alternative that involves lower cost is called “index investing”.
An index is essentially a set of stocks that meet certain requirements or have certain common characteristics to one another. For example the most popular index, the Standard and Poor’s 500. It’s an index that takes the 500 largest US stocks on the market.
What this means for index investing is that an S&P 500 Index Fund would be managed in a way to match the S&P 500 index. In other words, the mangers would simply try to buy and sell stocks to keep their investments in line with the 500 largest companies on the market. That’s how they can keep their management fees so low – they don’t have a ton of research to do.
But there are other indices. S&P 500 is the most popular but there are others like the Dow Jones Industrial Average (DJIA), which is 30 massive companies weighted according to price. The DJIA is the oldest index.
The following are some others that you might like to consider:
The Nasdaq Composite Index
The Nasdaq is actually a stock exchange that predominantly trades technology companies. The index seeks to perform according to the stocks on the exchange.
The Russell 2000
Of the 3000 largest companies in the Russell 3000 (another index), the Russell trades the bottom 2000. Thus, this fund trades mostly smaller to middle size companies.
There are many, many more you can look up on your own. The bottom line is that for most cases index funds provide the better choice.