A mutual fund pools money from many investors to buy a portfolio of stocks, bonds, or both. Shares are priced once per day at the net asset value (NAV).
Most 401(k) plans still offer mutual funds, not ETFs — so understanding fees and share classes is essential. The difference between a 0.04% index fund and a 1.2% actively managed fund can cost a retiree over $100,000 on a $500,000 balance over 20 years.
A mutual fund works by pooling money from thousands of investors and using that pool to buy a diversified portfolio of securities. A professional fund manager (for actively managed funds) or a computer algorithm (for index funds) decides what to hold. Every business day after the market closes, the fund calculates its net asset value per share by dividing the total value of all holdings minus expenses by the number of shares outstanding. When you buy or sell shares, you transact at that day's closing NAV, not at a live market price like an ETF.
Mutual funds come in several share classes, and this is where the fee structure gets confusing. Class A shares charge a front end load, typically 3% to 5.75%, taken out of your investment before it even starts working. If you invest $100,000 in a Class A fund with a 5% load, only $95,000 goes into the fund. Class C shares skip the front end load but charge a higher ongoing expense, often 1% more per year than Class A. Institutional shares, sometimes called Admiral shares at Vanguard, have lower expense ratios but require minimum investments, typically $3,000 to $100,000. Always ask your 401(k) plan administrator which share class is available to you, because the difference is significant.
The debate between active and passive mutual funds has largely been settled by the data. The S&P SPIVA scorecard, updated twice yearly, consistently shows that over 15 year periods, approximately 88% of actively managed US equity funds underperform their benchmark index after fees. The numbers are similar for bond funds and international funds. The small percentage of funds that do outperform in one period rarely repeat that performance in the next. This does not mean active management never works, but it does mean the odds are heavily against you picking the winner in advance.
For retirees who hold mutual funds in a 401(k), the practical move is to look at your plan's fund lineup and find the lowest cost index options. Most plans offer at least an S&P 500 index fund and a total bond market index fund. If your plan also offers a total international index fund, you have everything you need. If the cheapest option in your plan is still expensive, say above 0.50%, it may be worth rolling your 401(k) into an IRA after retirement where you can access lower cost funds directly.
Target date mutual funds deserve special attention because they are the default investment in most 401(k) plans. A target date fund automatically adjusts its mix of stocks and bonds as you approach your target retirement year. A 2030 target date fund might currently hold 45% stocks and 55% bonds, while a 2040 fund might hold 70% stocks and 30% bonds. The advantages are simplicity and automation. The disadvantages are that the glide path may not match your specific needs, and the expense ratios on target date funds average around 0.32%, which is reasonable but not as low as building your own two or three fund portfolio at 0.03% to 0.05%.
When evaluating mutual funds, look beyond the star rating. Morningstar ratings are backward looking and have limited predictive value. Instead, focus on the expense ratio, the fund's turnover rate (high turnover means hidden trading costs and tax inefficiency), the fund's tax cost ratio (Morningstar publishes this), and whether the fund has had consistent management. A fund that has changed managers three times in five years is not the same fund that earned its track record. Most importantly, compare any actively managed fund against the cheapest index fund in the same category. The active fund needs to overcome its fee disadvantage every single year, and the math makes that an uphill battle over the long run.
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