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Why Mutual Funds?

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Key Points

  • Mutual funds offer investors many attractive features, including built-in diversification, economies of scale, low minimums and liquidity.
  • Investors can opt for passive funds that track an index or actively managed funds that strive to outperform their benchmark.
  • Some mutual funds can provide investors access to niches or specialized areas of the market that may otherwise be out of their reach.
  • Perhaps most important: The ease and convenience of mutual funds can help investors avoid the risk of inertia—getting and keeping them invested with a long-term focus.

It may seem like a simple question with a straightforward answer, and at some levels it is. But there may be some advantages of mutual funds that you hadn’t considered. Here we address the many reasons why mutual funds have retained their popularity since their emergence nearly a century ago, and why, as of mid-2016, according to a survey by the Investment Company Institute, nearly 55 million U.S. households—representing 94 million individuals—own mutual funds.1

Built-In Diversification

Diversification, a key tenet of investing, provides a means for investors to manage their risk by spreading their investments across a large number of securities. The premise is that weakness in one holding, sector or geographic region can often be offset by strength in another, tempering potential volatility. Because they generally hold a large number of individual securities, mutual funds provide inherent diversification. And given the alternative of buying and managing a portfolio of individual securities, this is a particularly valued feature.

Diversification can be measured against a number of yardsticks, including across or within sectors, geographic regions, market cap (the number of outstanding shares of a security multiplied by its share price) or style characteristics, such as value or growth. Using mutual funds, investors have the ability to build a diversified portfolio by purchasing a variety of funds that focus on different areas of the market, such as large- or small-cap U.S. stocks or emerging markets funds. In many cases, each responds differently to different market cycles or events, so their movement is often uncorrelated.

Low Minimums

Most mutual funds offer low investment minimums. In addition to enabling smaller initial purchases, low minimums can allow investors to take advantage of what’s known as dollar-cost averaging—regular, periodic purchases that essentially result in more shares purchased when prices are low and fewer when they’re high. Low investment minimums provide an opportunity for investors who may not have amassed a lot to start investing early, as well as encourage disciplined, ongoing investing for the long term. Schwab clients can invest in most no-load mutual funds it offers for as little as $100, and many index funds are available with no minimum whatsoever.

Liquidity

Mutual funds are highly liquid, meaning they allow investors to redeem their fund shares at any time. While frequent buying and selling is generally discouraged—sometimes by the imposition of a short-term redemption fee if shares are sold within a specified time frame, or purchase restrictions as a result of violations of frequent-trading or market-timing policies—mutual fund investors can generally buy or sell shares with relative ease. Because funds are priced just once per trading day, after the close of trading (unlike stocks or exchange-traded funds (ETFs), which can be bought or sold throughout the trading day), mutual fund buy and sell orders are generally filled after the market close of the trading day on which they were placed.

Broad Market Coverage

While many mutual funds are broadly diversified across large swaths of the market, such as an S&P 500 Index Fund or a Total Stock Market Fund, other are more specialized. In many cases—for instance, stocks that trade only on a foreign exchange or small, focused bond issuances—those niches can be difficult for individual investors to access. Mutual funds can often provide such access. In addition, some specialized funds offer individuals exposure to alternative strategies, such as “smart beta” or low volatility, or to institutional-quality investment managers that may otherwise be out of reach.

Professional Management

Although some investors may relish the challenge of researching individual stocks and assembling a portfolio of diversified holdings, many do not. Even with index funds, which are passively managed and seek to replicate the index they track, investment professionals are involved in the operational aspects of fund management—for instance, regular rebalancing to maintain close tracking to their benchmark index. The potential value of professional management is more evident with actively managed funds, where professional money managers apply their insights and expertise to the investment process through research, analysis, portfolio construction and monitoring in an effort to outperform the market.

Low Costs

All funds incur expenses—known as an annual operating expense ratio, or OER—and they can represent a significant cost of investing, particularly over the long term. And the range in the costs associated with owning a mutual fund can be substantial, from a few hundredths of a percent to more than 2% per year. Depending on many factors, myriad funds are available with low OERs that can maximize an investor’s net investment. In addition, many mutual funds are available without loads (sales commissions) or transaction fees.

Discipline

The simplicity and ease of investing in mutual funds has another, less obvious benefit: getting and keeping investors in the market. Events such as the global financial crisis of 2008 or the Brexit sell-off in 2016 can cause even the most stalwart investors to flee the market, leaving them cautiously on the sidelines. While perhaps avoiding some market turbulence, such investors also run the risk of inertia—failing to reenter the market and exposing themselves to the possibility of losing purchasing power due to the impact of inflation. Understanding that markets are unpredictable, and that there will be ups and downs, getting and staying invested is critical for investors looking to accumulate wealth for the long term.

And There’s More…

Other advantages that mutual funds can offer:

  • Access to an all-in-one solution, such as a target date fund or a balanced fund
  • The opportunity to automatically reinvest dividends and capital gains
  • The transparency of publicly posted fund holdings
  • Audited track records to assess whether a fund follows its stated investment strategy
  • Governance and oversight by a board of directors acting in the interest of shareholders
  • For international funds, an added layer of diversification in the form of currency exchange

Beyond the monetary advantages, for investors who are interested in growing not only their net worth but also their knowledge, most mutual fund companies offer a wealth of information for their investors. Fund companies are obligated to report at least twice a year to shareholders on their performance and holdings, and many do so more frequently. Also, many mutual fund websites are replete with investment insights, so engaged investors can learn a lot about markets, cycles, strategies and more.

Early on, Schwab recognized the appeal of mutual funds to individual investors. For decades, we have focused on making mutual funds not only accessible, but also on making purchasing and owning them easy, convenient and cost-effective. With tools like the Mutual Fund OneSource Select List and Income Select List, as well as a host of educational resources available at schwab.com, investors can easily gauge whether mutual funds make sense for them.