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Can You Become Rich Investing in Mutual Funds?

Investopedia logoInvestopedia 23-10-2015 Claire Boyte-White
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Investing is one of the most popular ways to create wealth. By taking on a certain degree of risk, you can put your current assets to work for you and generate short- or long-term income, depending on your investment goals. Of course, the more risk you take on, the higher the likelihood of both success and failure. It is for this reason that riskier securities, such as stocks, are traditionally considered the go-to investments for those looking to strike it rich.

Since mutual funds are generally considered safer, more stable investments, it may seem counterintuitive that they can provide ample opportunities for aggressive wealth creation. In fact, some types of mutual funds are just as risky, or riskier, than individual stock investments and have the potential to generate huge returns. High-yield stock and bond funds, in particular, are specifically designed to generate the highest possible profits by investing in the riskiest assets.

High-Yield Stock Funds

There is a variety of different stock funds aimed at specific investor goals. High-yield funds, as the name suggests, are geared toward generating the maximum possible returns depending on the type of income shareholders are pursuing.

For investors who want to receive the maximum amount of annual investment income, high-yield dividend funds focus on stocks that consistently pay very high dividends. All mutual funds must distribute net gains to shareholders at least once annually, so high-yield dividend funds make at least one dividend payment each year. These funds are less focused on generating capital gains, so they do not trade securities frequently unless a stock's dividends are suspended or drop considerably. These are certainly not the most aggressive types of funds, but if you have a significant amount to invest, the dividend income generated each year can be substantial.

Other high-yield stock funds focus on the generation of capital gains by employing a highly aggressive trading style. This involves actively looking for the next big stock and attempting to time the upswing. Conversely, these funds may look to short stocks that are poised to take a big fall. These types of funds require a very active manager who has ample experience and keen instinct. There is a much higher degree of risk inherent in this type of stock fund relative to dividend funds, but it also offers greater opportunity for quick and substantial profits.

High-Yield Bond Funds

Stock funds are not the only mutual funds that can pave the way to riches. Though bond funds are typically touted as one of the safest types of funds, providing moderate annual income and the promise of capital preservation, high-yield bond funds are actually quite risky.

While funds that invest in bonds issued by highly rated corporations and governments generate the majority of their returns from interest payments, funds that invest in very low-rated bonds, called junk bonds, employ a much more short-term investment strategy. Instead of holding bonds until maturity and collecting annual coupon payments, junk funds capitalize on the volatility of junk bond values. Because the risk of default is so high, junk bonds often sell for far below their par values and pay extremely high interest. As national interest rates change or the issuing entities gain or lose credibility, the market price of these bonds can fluctuate dramatically. Junk funds generate returns by purchasing junk bonds cheaply, reaping the benefits of their generous coupon payments and selling them before the company defaults, hopefully for a profit. If the issuing entity stabilizes and its credit rating improves, the value of junk bonds can increase dramatically, generating even higher yields due to the bargain-basement purchase price.

Balanced Funds for the Moderate Investor

For those who are not ready to take on the extreme risk inherent in high-yield funds, there are many mutual fund options that provide the opportunity for big gains while still offering some stability. Balanced funds invest in both debt and equity and can be tailored to the specific goals and risk tolerance of their shareholders. For investors who want to invest in high-risk, high-reward assets without betting the farm, funds that play it relatively safe but still include some high-yield securities are a good fit. For example, a fund might invest primarily in highly stable bonds or buy-and-hold blue chip stocks with proven track records but also allocate a portion of its capital for investment in junk bonds or highly volatile stocks. Though the potential for serious wealth creation is limited, these funds offer long-term stability with just a dash of risk.

Low-Risk Bond and Money Market Funds: Slow but Steady Growth

Like any investment, the more you can afford to put in, the greater your potential returns. It is hard to get rich investing only $1,000 in any type of security. If you have a significant amount to invest, however, you can generate a sizable amount of income even with the most stable investments.

Though low-risk bond and money market funds are not exactly the superstars of wealth creation, they do offer a very high degree of stability with the promise of fixed income each year. If you have an ample sum to invest, even moderate interest rates can generate hefty sums. For example, $500,000 invested in a money market fund that pays only 3% annually still generates $15,000 in investment income each year, which is more than some people earn in a year. The wealthier you are to begin with, the easier it is to become obscenely rich in a short period.

The Impact of Management Fees

When looking to generate wealth through mutual fund investments, it is important to consider the impact of a fund's expense ratio. In general, more actively managed funds, such as high-yield bond and stock funds, tend to have higher expense ratios to compensate for the increased trading fees. If the expense ratio of a given fund is very high, it can eat up a substantial portion of your annual profits.

Investment Income and Tax Liability

Another important consideration when choosing a mutual fund is the impact of investment income on your tax bill. Depending on the type of income a mutual fund generates, you may find yourself paying more in taxes than anticipated. Funds that generate short-term gains, as high-yield funds generally do, can create significant tax liability because short-term investment income is taxed at your ordinary income tax rate rather than at the lower capital gains rate that applies to long-term profits.

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