Advertiser Disclosure

What Is a Mutual Fund and How Does One Work?

A mutual fund pools cash to buy stocks, bonds and other assets, giving investors a cost-effective way to diversify and reap market gains.
Dec. 13, 2018
Investing, Investments
How Do Mutual Funds Work?
cheatgame.info adheres to strict standards of editorial integrity to help you make decisions with confidence. Some of the products we feature are from partners. Here’s how we make money.
We adhere to strict standards of editorial integrity. Some of the products we feature are from our partners. Here’s how we make money.

You want to invest your money, but also want to avoid some of the risks and hassles that come with picking individual stocks? Mutual funds provide the benefits of a diversified portfolio without the time required to manage one.

Mutual funds are one of the most common tools investors use to build long-term retirement savings. If you have a 401(k), a pension, a traditional individual retirement account or a Roth IRA — really, any kind of brokerage account to invest your cash — there’s a good chance your portfolio includes mutual funds.

What are mutual funds?

A mutual fund pools money from a bunch of different investors in order to invest in a large group of assets. Unlike the stock market, in which investors purchase shares from one another, mutual-fund shares are purchased directly from the fund or, more often, a broker who purchases shares for investors.

The fund is managed by a professional who makes daily decisions on buying and selling the securities held in the fund, decisions that are based on the fund’s goals. For example, in a fund whose goal is high growth, the manager might try to achieve better returns than that of a major stock market like the S&P 500. Conversely, a bond-fund manager tries to get the highest returns with the lowest risk.

Mutual fund investors share equally in losses and gains, helping to spread the risk from bad investments and, over time, reaping total gains.

Investors in a mutual fund share equally in losses and gains. This helps to spread the risk from bad investments while, over time, reaping total gains of the fund.

Fund investors usually pay annual fees for the running of the fund, known as expense ratios, which are based on a small percentage of the total value of your shares. Paying attention to account minimums and fees can be an important way to choose among mutual funds.

» Ready to get started? Here’s our list of the best brokers for mutual funds

How do I make money from mutual funds?

When you invest in a mutual fund, cash or value can increase from three sources:

  • Dividend payments: When a fund receives dividends or interest on the securities in its portfolio, it distributes a proportional amount of that income to its investors. When purchasing shares in a mutual fund, you can choose to receive your distributions directly, or have them reinvested in the fund.
  • Capital gain: When a fund sells a security that has gone up in price, this is a capital gain. (And when a fund sells a security that has gone down in price, this is a capital loss.) Most funds distribute any net capital gains to investors annually.
  • Net asset value (NAV): As the value of the fund increases, so does the price to purchase shares in the fund (known as the NAV per share). This is similar to when the price of a stock increases — you don’t receive immediate distributions, but the value of your investment is greater, and you would make money should you decide to sell.

What are the benefits of a mutual fund?

There are two primary benefits to investing in mutual funds:

  • Diversification. This is one of the most important principles of investing. If a single company fails, and all your money was invested in that one company, then you have lost your money. However, if a single company fails within your portfolio of many companies, then your loss is constrained. Mutual funds provide access to a diversified portfolio, without the difficulties of having to purchase and monitor dozens of assets yourself.

    Mutual funds provide cost-effective investing without the time and expertise required to buy, sell and monitor hundreds of assets.

  • Simplicity. Once you find a mutual fund with a good record, you have a relatively small role to play: Let the professional fund managers do all the heavy lifting.

The main disadvantage to mutual funds is that, because the fund is managed, you’ll incur fees no matter how the fund performs. Investors have to pay sales charges, annual fees, and other expenses with no guarantee of results. (We’ll cover more on fees below.)

Also, some people don’t like the lack of control with a mutual fund; you may not know the exact makeup of the fund’s portfolio and have no control over its purchases. However, this can be a relief to some investors, who simply don’t have the time to track and manage a large portfolio.

» Interested instead in DIY investing? Understand how to buy stocks

Are mutual funds safe?

All investments carry some risk, and you could lose money in a mutual fund. But diversification is inherent, meaning you’ll spread risk across an number of companies or industries. Investing in individual stocks, on the other hand, can carry a higher risk. If you put all your money in Apple stock, for example, a bad quarter could have a disastrous impact on your savings. But with a mutual fund that’s invested across the technology sector, gains by other companies could help offset any single company’s loss.

For mutual fund investors, time is a crucial element in building the value of your investments. Don’t invest cash you will need in five years or less, because you’ll want to ride out the inevitable peaks and valleys of the market.

What do mutual funds invest in?

Some mutual funds focus on a single asset class, such as stocks or bonds, while others invest in a variety. These are the main types of mutual funds:

  • Stock (equity) funds carry the greatest risk alongside the greatest potential returns. Fluctuations in the market can drastically affect the returns of equity funds. There are several types of equity funds, such as growth funds, income funds and sector funds. Each of these groups tries to maintain a portfolio of stocks with certain characteristics.
  • Bond (fixed-income) funds are less risky than stock funds. There are many different types of bonds, so you should research each mutual fund individually in order to determine the amount of risk associated with it.
  • Hybrid funds invest in a mix of stocks, bonds and other securities. Many hybrid funds are funds of funds; they invest in a group of other mutual funds. One popular example is a target date fund, which automatically chooses and reallocates assets toward safer investments as you approach retirement age.
  • Money market funds have the lowest returns because they carry the lowest risk. Money market funds are legally required to invest in high-quality, short-term investments that are issued by the U.S. government or U.S. corporations.

How funds are managed: Active vs. passive

No matter which category a mutual fund falls into, its fees and performance will depend on whether it is actively or passively managed.

Passively managed funds invest according to a set strategy. They try to match the performance of a specific market index, and therefore require little investment skill. Since these funds require little management, they will carry lower fees than actively managed funds.

Two types of mutual funds popular for passive investing:

  • Index funds track a market index, such as the S&P 500 or the Nasdaq. These funds are made up of the stocks comprising a particular index, so the risk mirrors that of the market, as do the returns.
  • Exchange-traded funds can be traded like individual stocks but also offer the diversification benefits of mutual funds. They generally charge lower fees than traditional mutual funds, but active traders might find their costs too high.

    Studies show passive investing strategies often deliver better returns.

Actively managed funds seek to outperform market indices, and carry the potential for greater return than passively managed funds. They also carry higher potential rewards as well as risks: Studies show passive investing strategies often deliver better returns.

Understanding mutual fund fees

Mutual fund investors pay two basic types of fees: expense ratios and sales commissions, which are known in the industry as sales loads.

Mutual fund expense ratios are the cost of ongoing expenses — such as fund administration and operating costs. They are paid annually as a percentage of your total assets in the fund. As noted above, passively managed funds have lower expense ratios compared to actively managed accounts, as they require fewer financial professionals and other overhead costs.

So it pays to shop around, and statistics show more mutual fund investors are doing just that. For example, in 2017 the average equity mutual fund charged an expense ratio of 1.25%, but the average equity-fund investor paid only 0.59%, according to the Investment Company Institute. That might not seem like a big difference, but over time it can add up to tens of thousands of dollars in lost retirement savings.

Another common expense are sales loads. These are commissions paid at the time of share purchase (front-end loads) and when redeemed (back-end loads). Sales loads are compensation paid to financial professionals, such as a broker or investment advisor, to buy mutual fund shares.

Mutual funds come in four different structures that will impact fees you’ll pay:

  • Open-end funds: Most mutual funds are this variety, where there is no limit to the number of investors or shares. The NAV per share rises and falls with the value of the fund.
  • Closed-end funds: These funds have a limited number of shares offered during an IPO, much as a company would. There are far fewer closed-end funds on the market compared to open-end funds.

Whether or not funds carry commissions are expressed by “loads,” such as:

  • Load funds: Mutual funds that pay a sales charge or commission to the broker or salesperson who sold the fund in addition to the NAV share price.
  • No-load funds: Also known as “no-transaction-fee funds,” these mutual funds charge no sales commissions for the purchase or sale of a fund share. This is the best deal for investors, and brokers such as TD Ameritrade and E-Trade have thousands of choices for no-transaction fee mutual funds.

How to buy mutual funds

You can purchase through an employer-sponsored retirement account like a 401(k), or directly from a fund provider such as Vanguard, Fidelity or American Funds. Both options, however, can limit your choice of funds.

You’ll have more choices if you open a brokerage account to begin investing. There may be a minimum deposit requirement, but some providers offer $0 minimum if you invest through an IRA or if you set up automatic monthly deposits.

cheatgame.info’s Maxime Rieman contributed to this article.