What are mutual funds and how do they work?
June 22, 2023 7 min read
Trying to learn about investing can be complicated. But one place to start could be with a mutual fund.
Mutual fund investments can help you build wealth while owning a diversified portfolio that you may not otherwise be able to afford on your own. Keep reading to learn what mutual funds are, how they work and how to invest in them.
- A mutual fund is an investment portfolio consisting of stocks, bonds and other securities.
- Mutual funds offer small and individual investors access to a well-diversified portfolio of investments that are professionally managed by a fund manager.
- Mutual funds charge fees that can affect returns.
What is a mutual fund?
Mutual funds are registered as investment companies with the Securities and Exchange Commission (SEC). Professional fund managers—or money managers—operate these funds and are required to work in the best interest of all shareholders.
How do mutual funds work?
Mutual funds are purchased through a broker or fund manager. Instead of owning shares in the individual companies that make up the fund, investors buy shares in the fund, which represent their ownership. And the investors share in the fund’s profits and losses.
Most mutual funds are open-end investments, which means there’s no limit to the number of shares that may be sold in the fund.
Unlike stocks, mutual funds don’t trade throughout the day. Instead, shares are priced at the close of each trading day. The price is the per-share value of the fund’s assets minus liabilities, known as net asset value (NAV).
Mutual fund returns
As with any investment, there’s always the risk of losing money. But investors can earn returns in a few ways—usually on a quarterly or annual basis. They include:
- Distributions: These come from dividends on stocks and from interest on bonds within the mutual fund.
- Capital gains: When the fund sells a security with a price increase, the fund has what’s called a capital gain. Capital gains are paid to investors annually and are distributed after any losses are accounted for.
- Profits on shares: When the mutual fund increases its share price, investors can sell their shares of the fund for a profit.
Types of mutual funds
Although there are a variety of mutual funds available, most are stock funds, bond funds, money market funds or target date funds.
Stock funds, also known as equity funds, mainly invest in corporate stocks. Investors may choose from a broad range of stock funds with different objectives.
There are many different types of stock funds. For example:
- Growth funds consist of stocks with above-average returns, but they might not pay regular dividends.
- Income funds consist of stocks with regularly paid dividends.
- Index funds are designed to mirror the performance of a specific index, such as the S&P 500.
- Sector funds target a particular industry segment.
- ESG funds evaluate a company’s environmental, social and governance impact.
- Regional funds focus on stocks within a particular region or country.
Money market funds
Money market funds are generally considered a lower-risk option than stocks and bonds. That’s because they consist of certain high-quality, short-term debt investments, such as government treasury bills. However, they usually offer a return on investment that isn’t much higher than that of a typical savings account.
Bond funds are considered higher risk than money market funds due to the many types of bonds, risks and higher rewards they offer. Bond funds usually consist of exchange-traded funds (ETFs), mutual funds, closed-end funds and unit investment trusts (UITs). Although each type and level of risk is different, they allow for diversification.
Target date funds
Target date funds—or lifecycle funds—are designed for investors with specific retirement dates. They consist of stocks, bonds and other investments, but as the fund’s strategy changes over time, the mix adjusts.
Active vs. passive funds
As an investor, it’s important to understand the difference between active and passive investing, because each may offer different returns and risks.
Active mutual funds are managed by a professional fund manager and take a hands-on approach to investing. On the other hand, passive funds don’t require the assistance of a fund manager and analysts. Instead, they use an algorithm to track the performance of an index like the S&P 500.
Although active funds rely on the experience and expertise of a professional to evaluate funds and track their performance, they don’t necessarily outperform the market. And these types of funds often come with higher fees since they require more hands-on work from the investment team.
Even passively managed funds need to be rebalanced—or adjusted—so your asset allocation can match investors’ financial goals and risk tolerance. Since these funds don’t require as much work from fund managers, they typically cost less.
Mutual fund share classes
In addition to being classified as active or passive, mutual funds are also often sold in different share classes. The primary differences between the three main share classes are their specific fees:
- Class A shares: These shares charge an upfront sales fee, called a front-end sales load. But they generally come with lower annual expenses. For example, the 12b-1 fee, which covers costs associated with marketing and selling shares, is often lower.
- Class B shares: These shares don’t usually have a front-end sales load. But they might have a back-end sales load and a higher 12b-1 fee than Class A shares. The back-end sales load usually decreases the longer you hold the shares.
- Class C shares: Class C shares may have either a front-end or back-end load, but it’s usually lower than the costs associated with Class A or B shares. However, Class C shares often have higher annual fees than the other two share classes.
Mutual fund fees
Mutual funds charge operating fees and expenses directly to their investors. Fees can differ and may be charged at certain times—and some might be regular and ongoing. It’s important to be aware of these fees since they can have an impact on returns.
Common fees associated with a fund may include:
- Management fees
- Administrative fees
- Legal and accounting service fees
- Account fees
- Redemption fees
- Purchase fees
- Exchange fees
- Transaction fees
Detailed fees can be found in each fund’s prospectus—a written document that describes the fund. You could also use the Financial Industry Regulatory Authority’s Fund Analyzer tool to estimate a specific fund’s fees.
Are mutual funds safe?
Like all investments, mutual funds carry risks that are important to understand prior to investing. When investments increase, investors usually benefit from those gains. When they decrease, investors usually experience losses.
So why do people invest in mutual funds? There are a few things that might make mutual funds attractive investments, including:
- A diversified portfolio: Mutual funds could offer you the opportunity for diversification—to invest in a wide range of industries, companies and investment types. And that may mean lower risks in case a company fails.
- More affordable investment: Mutual funds might allow those without big investment budgets to own a piece of some of the most well-known companies at an affordable price.
- Professional management: One of the perks of investing in mutual funds is that you don’t have to do the research involved in choosing the investments. Fund managers choose them for you and keep an eye on their performance.
- Liquid assets: Investors can liquidate their shares whenever the market is open for the NAV and redemption fees.
Mutual funds in a nutshell
Mutual funds might allow individual investors to buy into a well-diversified portfolio of securities, but they don’t come without risks. As with any other investment, it’s important to understand the pros and cons of investing in mutual funds to decide what’s right for you. Talking to a financial expert if possible could help you determine whether this type of investment will fit into your financial goals.