Mutual Funds: Everything You Need To Know

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A mutual fund pools money from many investors and invests it in securities such as stocks, bonds and other assets. The combined holdings of the mutual fund are known as its portfolio. Investors who buy shares in the fund receive part ownership of it and the income generated when investments in the fund’s portfolio increase in value.

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If you have a 401(k) plan at work or an individual retirement account on your own, you might already own mutual funds. But how do mutual funds work? How can you buy mutual funds? Learn the answers to these questions and more.

What Is a Mutual Fund?

A mutual fund is a collective pool of investments. When different investors buy shares, managers take that money to purchase various securities. Each investor owns a fractional percentage of each investment in the fund, in proportion with the number of shares they own. All investors in the fund earn the same return, as they each own the same securities.

An equity mutual fund, for example, might own 100 or more different stocks. Even if you only invest $1,000 into the fund, you will become a partial owner of each of these individual securities. You don’t have the right to trade any individual securities within the fund — that’s the responsibility of the fund manager(s). But you participate in the daily gain or loss of the fund, just like every other investor in the fund.

Mutual funds can be structured in several different ways:

Open-End Funds

Open-end funds are the most common type of mutual fund. They are bought and sold on demand, and they are not limited as to the number of shares they can offer. The price of each share in open-end funds is calculated at the end of each trading day by dividing the market value of the securities in the fund, minus expenses, by the number of shares.

So if the price of the stocks and bonds held in your mutual fund goes up, the price of the mutual fund goes up and the value of your investment increases.

Load Funds

Load funds charge a sales charge, or load, when you either buy or sell the fund. When you are deciding whether or not to purchase a mutual fund, make sure you factor in the load, because it can vary and can impact the average mutual fund return. The law doesn’t set limits on mutual fund loads, but the Financial Industry Regulatory Authority caps them at 8.5% of the purchase or sale price.

No-Load Funds

No-load funds do not charge a sales load, but that doesn’t mean they’re necessarily cheaper than load funds. They may charge other fees for operating expenses, so understand any fees that you will be charged when you purchase mutual funds.

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How Are Mutual Funds Managed?

Mutual funds can be managed in one of two ways: actively or passively. An actively managed mutual fund has a fund manager who buys and sells investments within the fund with the goal of outperforming the market relative to a benchmark, such as the S&P 500. The performance of an actively managed fund is based on how well it does compared with the benchmark.

A passively managed mutual fund includes investments that mirror the investments in the benchmark with the goal of having the same performance as the benchmark. So a passively managed fund that uses the S&P 500 as its benchmark will include stocks in the 500 companies that make up the S&P 500 index. These are the 500 largest companies traded on U.S. stock exchanges.

Understanding the Types of Mutual Funds

Here’s a look at five major types of mutual funds.

Stock Funds

Stock funds invest in the stock of corporations. They may invest in several companies in a given industry, such as technology or energy. Or the fund may seek to invest in new companies or those in emerging markets. The stocks may be chosen for their ability to provide income in the form of dividends or growth in the form of price appreciation.

Bond Funds

Bond funds may contain various types of bonds. Bonds are debt instruments that corporations and governments issue when they need to raise money. Bonds often pay dividends and usually don’t appreciate in value.

Individual bonds will mature, meaning that the issuer will pay the investor back the face value of the bond, but bond mutual funds replace maturing bonds with new bonds to keep the fund going.

Money Market Funds

Money market funds invest in high-quality, short-duration investments issued by U.S. corporations or government entities. They are very safe and produce relatively low but consistent returns.

Balanced Funds

Balanced funds own both stocks and bonds in an attempt to have consistent growth in any type of market. Often, when bond returns increase, stock returns decrease, and vice versa, so a fund that holds both bonds and stocks has a good chance of growth over time.

Target-Date Funds

Target-date funds hold stocks, bonds and other investments and are bought with a specific date in mind, such as retirement. They start out with a relatively aggressive mix of investments, meaning a high percentage of stocks. As the target date approaches, the investment mix becomes more conservative.

When you’re saving for retirement, you want to take less risk the closer you are to retirement, so a target-date fund is a good way to accomplish this.

What’s the Difference Between a Mutual Fund and an ETF?

Exchange-traded funds are similar to mutual funds in that they pool investors’ money to invest in baskets of securities. However, ETFs are traded like stocks, so you can buy and sell shares whenever the markets are open, whereas mutual funds trade at the end of the day.

ETFs also require less of a minimum investment. Whereas many mutual funds require a minimum investment of $1,000 or more, you can find some ETFs that cost under $100, and you can, in many cases, purchase fractional shares.

How To Make Money on Mutual Funds

You can make money on mutual funds in two primary ways: through capital appreciation or income, and sometimes both. 

If you can sell your mutual fund at a higher price than you bought it, you can earn a capital gain. This is more likely with growth funds, such as those that invest in stocks. 

You can also earn money from regular dividend or interest payments from a mutual fund. These types of funds tend to invest in income-generating securities, such as bonds or preferred stocks. 

Some funds are hybrids that offer both growth and income, often from investing in dividend stocks that pay high yields. 

Mutual funds can increase in value, but they can also decrease in value. If the value of the securities in the fund declines, the net asset value of the fund will decline. You can lose money that is invested in mutual funds, so be sure that you understand the risk you’re taking on.

What Are the Benefits of Investing In Mutual Funds?

Here’s a look at the major reasons you might choose to invest in a mutual fund.

Diversify Your Portfolio

The expression “Don’t put all your eggs in one basket” is particularly relevant when it comes to investing. If you invest all your money in one company’s stock, you could lose everything if that stock does poorly. Diversification in investing means more than just buying stock in a few different companies, though. A diversified portfolio will include stocks, bonds and cash, and it will be invested in many different industries.

Mutual funds typically have a diverse selection of investments in the fund already, so buying shares of a single fund can do the diversification for you. If you don’t have a large amount of money to invest, mutual funds are an effective way to diversify your investments.

Benefit From Professional Management

Mutual fund companies hire professional fund managers to choose and monitor the investments in each mutual fund. These people are highly trained, and they spend their day watching the investments in their funds, removing those that perform poorly and replacing them with ones they think will perform better.

Access to Your Funds

You can sell your mutual fund shares on any day the markets are open. When you do, you’ll get the current price, or net asset value, as of the market’s close, less any fees for redeeming the shares.

Value

Whereas you’d need a large investment to buy a diverse portfolio of individual stocks and other assets, you can invest a relatively small amount of money in a mutual fund and add to your investment slowly over time.

What Are the Drawbacks of Investing In Mutual Funds?

No investment vehicle is perfect. Here are some of the drawbacks to investing in mutual funds.

Risk of Losing Money

All investments have some level of risk. Unlike putting your money in the bank, when you invest, you could lose some or all of your money.

No Control Over Investments

Mutual funds are managed by professionals. When you buy shares in a fund, someone else controls the stocks your money is invested in.

Fees

Another drawback of investing in mutual funds is their fees. You may pay a sales charge (load) on the funds you buy. Mutual funds also charge operating fees, which can reduce the value of your portfolio. You may also pay a redemption fee when you sell shares, an exchange fee if you exchange shares in one fund for shares in another, an account fee if your account falls below a minimum or a purchase fee when you buy shares.

Potentially Lower Returns

Mutual funds hold cash to ensure they can pay shareholders who sell shares, and also to buy new securities for the fund’s portfolio. The value of cash doesn’t change like securities do, so the more cash a fund holds, the fewer appreciating assets it contains.

Taxes

All mutual fund shareholders receive the same distribution at the end of the year. If the fund appreciates during the year and you buy your shares right before the distribution, you’ll pay tax on the year’s worth of capital gains even though you didn’t receive all those gains, according to Fidelity. High turnover among shares can also drive up capital gains tax because the fund must report a gain each time a share is traded.

How To Invest In Mutual Funds

To buy mutual funds, you must open an account with a broker, such as E-Trade or Charles Schwab. Some brokerages, such as Vanguard and Fidelity, have their own funds but also let you buy funds from other companies.

Once you have an account, you can buy and sell funds by calling your broker or trading online. Each time you purchase a new fund, you should read the fund’s prospectus so you understand how the investments are selected and what the fees are.

Here are the specific steps you’ll want to take to invest:

1. Either open a new account or add enough money to an existing account at a brokerage that offers mutual funds.
2. Screen potential funds across various metrics according to your investment objectives and risk tolerance. For example, you might want to prioritize funds by return over a specified period, such as year to date or over five years, or screen by fees, minimum purchase amounts or overall risk.
3. Select the amount that you want to invest in one or more funds, and set up your trades with your brokerage. Generally, this involves clicking on the name of the fund and typing in the dollar or share amount you want to purchase. You may also be able to set up recurring investments at the time of purchase. At some brokerages, you can enter your trade over the phone, but you may have to pay additional fees.

After you make your purchase, it’s important to monitor the performance and any objective changes of your fund. While you should avoid tracking it from day to day, checking periodically, such as once per month or quarter, is often recommended by advisors. 

If you ever wish to sell your fund, you’ll undertake essentially the same action: Click on the fund in your account, enter the amount that you want to sell, and submit the order to your brokerage firm. 

Are Mutual Funds Good Investments?

Mutual funds can be excellent investments for the right investor. The best mutual funds to invest in are those that have a history of solid performance and low expenses and fees. Each fund has a prospectus, available on the company’s or broker’s website, that gives you the information you need to evaluate its quality and suitability for your portfolio.

Are Mutual Funds Right for You?

Mutual funds are a good choice if you prefer to have someone else make the decisions about which companies to invest in, and if you want to buy and hold your investments. The fees associated with mutual funds make them a poor choice for someone who wants to buy and sell frequently.

John Csiszar and Daria Uhlig contributed to the reporting for this article.

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