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How Do Mutual Funds 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.
Oct. 2, 2012
Investing, Investments
How Do Mutual Funds Work? 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 the risks and hassles associated with picking individual assets? Mutual funds provide the benefits of a diversified portfolio without the time required to manage one.

What exactly 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 a broker who purchases them directly from the fund).

Mutual funds are one of the most common tools investors use to build 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 high likelihood your portfolio includes mutual funds.

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

Types of mutual funds

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. (Here’s more about how to invest in stocks and stock funds.)
  • 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.

Active vs. passive funds

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

Passively managed funds invest according to a predetermined 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 Standard & Poor’s 500 or the Nasdaq. These types of funds are made up entirely 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.

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.

Studies show passive investing strategies often deliver better returns.

Actively managed funds have higher fees — called expense ratios — than passive funds. Expense ratios range from around 0.05% to 1% or more, and are charged annually as a percentage of your investment. A high expense ratio can erode investment returns over time, so pay close attention to these fees.

The benefits and downsides to mutual funds

There are two primary benefits to investing in mutual funds:

  • Diversification 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 out of your diversified portfolio, then you have only lost a small amount. Mutual funds provide access to a diversified portfolio, without the difficulties of having to monitor dozens of assets daily.

    Mutual funds provide access to a diversified portfolio, without the difficulties of having to monitor dozens of assets daily.

  • Simplicity is the key role of mutual funds. Once you find a mutual fund with a good record, you have a relatively small role to play. Some people don’t like the lack of control associated with a mutual fund; you don’t know the exact make-up of the fund’s portfolio and have no control over its purchases. However, this can be a relief to investors that simply don’t have the time to track and manage a large portfolio.

The main disadvantage to mutual funds is that, because the fund is managed, fees will be incurred no matter how the fund performs. Investors have to pay sales charges, annual fees, and other expenses with no guarantee of results. That said, most any method of investment will incur fees without a guarantee of results.

How do I earn 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. 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: The value of the fund increases. This is similar to when the price of a stock increases; you don’t receive immediate distributions, but your investment’s value is greater, and you will have made money should you decide to sell it.

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 individual retirement account such as a traditional or Roth IRA, or if you set up automatic monthly deposits.