The word “mutual” indicates something shared with others or done together. This explains the basic principle behind mutual funds. They are literally a vehicle for people—in this case investors—to get together, pool their money, and buy different assets with various levels of risk, all rolled into a single security.

This allows the investors to achieve easily—and at low cost—what would be difficult to accomplish alone, mainly diversification. And because shares of mutual funds can be easily bought and sold, they provide the fund holders with liquidity.

What are mutual funds and how do they work?

A mutual fund is a blended investment product that combines tens, hundreds, or in some cases, even thousands of different securities into one fund. This group of securities is curated based on any number of features or investment goals, focusing on everything from diversification to specific industries, stock market indexes, and even income generation. 

Investors purchase shares of a mutual fund in much the same way they would purchase shares of a publicly traded company. The difference, though, is that instead of owning a company’s shares outright, the mutual fund shares represent a tiny ownership stake in the shares of each company (or other assets held by the fund).

Mutual funds are managed by investment professionals. They charge fees—expressed as a percentage—based on the total value of the assets under management. Each year, investors pay their share of these operating costs, called expense ratios, which are withdrawn directly from the mutual fund’s assets. 

Over time, the value of an investor’s mutual fund shares may grow, or generate dividend income. Although mutual funds are bought and sold much like stocks, there is a difference: the fund issuer is the buyer and seller. When an investor wants to sell a fund, the mutual fund company redeems the shares, with little or no delay. Although this is different from buying and selling a company’s shares on an exchange, in which investors trade with one another, the practical effect is almost the same—plenty of liquidity.

What are the 4 main types of mutual funds?

While there are many different types of mutual funds, most fall into one of the following four categories:

1. Target-date funds.

   These mutual funds include a blend of stocks, bonds, and other securities in order to balance the risk tolerance for a group of investors. These funds are established and managed according to a specific target date, often the time when an investor expects to retire. Over the years, the asset allocation within a target date fund will shift, moving from a higher-risk, higher-return blend (often heavy in stocks) to a lower-risk mix (heavier in bonds) as the target date approaches.

2. Equity funds.

   These mutual funds, also known as equity funds, hold shares in publicly traded companies. The behavior and characteristics of stock funds can vary widely. For example, some may offer dividends while others focus on higher share price appreciation. Some stock funds may also track specific market indexes, such as the Standard & Poor’s 500 Index, while others focus on a particular industry, such as technology or energy.

3. Bond funds.

   Bond mutual funds focus primarily on bond investments, also known as fixed-income investments. These funds are typically lower risk than stock funds, while the specific fund can be short- or long-term in nature and can have varying returns.

4. Money market funds.

   The lowest-risk fund in this list is the money market fund. These funds consist of high-quality—but short-term—investments such as U.S. Treasury bills, corporate and bank debt, and government bonds or other securities. These tend to offer higher returns than interest-bearing bank products, like savings accounts, with low volatility. Investors often use money market funds to park spare cash that they anticipate using in the near future.

What is the difference between open- and closed-end funds?

Most mutual funds are open-end funds. This means that additional shares of the fund can be issued at any time, if the fund company so chooses. These shares are sold directly by the fund itself or through an approved broker, and are not traded among other investors on the open market.

The lesser-known closed-end funds, on the other hand, represent funds that are introduced with a ceiling on the number of shares issued. The fund’s shares are sold to investors in an initial public offering (IPO), raising capital to invest in the underlying assets. The shares are traded on the open market in the same way that stocks and ETFs are, though no new shares are issued.

What are the potential benefits and risks of mutual funds?

There are many reasons that investors might consider adding mutual funds to their investment portfolio. But there are also some things to keep in mind.

Potential benefits of mutual funds

• Diversification.

  A mutual fund is made up of tens, hundreds, or even thousands of different assets, often including a blend of stocks, bonds, and other securities. This allows investors to diversify their portfolio with just one investment, and also balance their investments according to their personal risk tolerance.

• Low costs.

  On average, mutual funds charge less than an advisor who creates an investment portfolio tailored to an individual investor’s goals.

• Lower risk.

  Although mutual funds are subject to price swings, this tends to be lower than the volatility in specific, individual securities.

• Dividends.

  Aside from any growth in value that the mutual fund recognizes, the securities held in the fund may also offer dividends to investors. These distributions are passed through to investors either in the form of passive income or reinvestment in the funds.

• Focus.

  Many mutual funds allow investors to invest in a specific industry or market. For instance, an investor could choose a mutual fund that concentrates on energy production and distribution; buying shares of that mutual fund would allow them to invest in many different related companies at once.

Risks of mutual funds

• Lower returns.

  Funds that are designed to mitigate losses usually forgo the potential for higher returns.

• Management costs.

  In addition to annual management costs, mutual fund investors may also incur fees for purchases, redemptions, exchanges, distribution, and even general account maintenance, especially if their account balance falls below a specific threshold.

• One size fits all.

  Mutual funds are built with specific goals and investment styles in mind, but they can’t be customized to an individual investor’s goals or needs. 

• Trading limitations.

  Unlike stocks and exchange-traded funds (ETFs), which can be bought or sold at any point in the trading day, mutual funds can only be purchased or sold at the end of the trading day.

The bottom line

Mutual funds are versatile investment products that offer diversification, risk management, and in many cases, passive income to investors. They come in a wide variety of flavors, each of which can serve a different purpose in a well-rounded investment portfolio.

These blended investments can include tens or even thousands of individual stocks, bonds, or other securities, and are usually actively managed to help meet their targets. In some cases, however, mutual funds are passively managed and simply track an index. Choosing a mutual fund usually depends on an investor’s short- and long-term goals, individual risk tolerance, and even their personal passions.