A mutual fund is a type of investment that pools a group of investors’ resources to access a bundle of stocks, bonds, or other securities.
When you buy a stock, you invest in a company’s equity. In contrast, when you invest in a mutual fund, you buy shares of a business that buys stocks in other companies or securities. Mutual fund holders don’t have voting rights the way they do with stocks.
Professional money managers oversee mutual funds on investors’ behalf. You can buy into a mutual fund through a large traditional investment firm like Charles Schwab or T. Rowe Price, or newer digitally-native firms.
How do mutual funds work?
The price of a mutual fund, which determines what you pay for its shares, is called its net asset value (NAV). To calculate a fund’s NAV, you divide the total value of all the securities in its portfolio by the number of shares owned by shareholders, institutional investors, and company stakeholders, among others. As opposed to stock prices, which fluctuate with the market, the NAV is set at the end of each day of trading.
How investors earn returns from mutual funds
Money invested grows when the value of the fund increases, based on gains in the underlying assets. The securities the fund owns also earn dividends and interest, which the fund passes through and distributes to shareholders. The fund may sell securities when they rise in value, and you and other investors are owed a share of this money.
You’re responsible for paying any taxes on this money, particularly income taxes (for dividend and interest payouts) and capital gains taxes for securities trading.
Active vs. passive mutual funds
With active funds, professional money managers oversee the fund’s portfolio. They buy and sell securities in the fund, whereas a casual investor may lack the time, resources, or expertise to commit to this trading.
Passively managed funds aim to replicate the moves of a market index like the S&P 500 and don’t require an investor’s oversight. One well-known example is the Vanguard 500 Index Fund. Passively managed funds generally have lower fees than actively managed funds.
Types of mutual funds
There are different types of mutual funds for nearly every type of investor and investing approach:
- Stock funds. Stock mutual funds, or equity funds, invest in a group of stocks. As with buying individual stocks, this type of mutual fund has greater financial risk given the stock market’s fluctuations.
- Bond funds. Bond funds invest in bonds. Bonds are a kind of debt issued by companies or the government as a tradable asset. Investors who buy the bonds are essentially lending out their money, and they are paid interest in return. These funds carry a lower risk than stock mutual funds.
- Balanced funds. Balanced mutual funds invest in a variety of securities, from stocks and bonds to certificates of deposit (CDs). They aim to maximize value while reducing risk by diversifying in a number of assets.
- Money market funds. Money market funds have lower risk than other mutual funds and purchase short-term debt issued by the government, banks, or corporations.
- Target-date funds. Target-date funds account for your age, investing aggressively when you’re younger, and theoretically can take on more risk, then making safer bets on bonds and the like as you near retirement.
How to buy mutual funds
First, you should decide if you want an actively or a passively managed fund. Passive investing means you are likely to ride the waves of the markets the fund has invested in. This has been a boon for investors, as in recent years, when global stocks reached all-time highs. Still, passive funds are susceptible to market downturns.
An actively managed mutual fund tries to outperform the market, picking which securities a fund manager or team of managers believe will fare better than average. Some funds run by star managers consistently outperform; many don’t.
Many employer 401(k) retirement plans offer mutual funds as an option for participating employees. The same is true of other retirement accounts like IRAs, or individual retirement accounts, to which you contribute without an employer.
Mutual fund fees
Most mutual funds charge investors fees for their services. In most cases, these fees will be deducted from your account balance.
- Maintenance fees. As with other investment products, mutual funds come with operating fees. An annual fee for management is also called an expense ratio. Say you put $500 in a mutual fund. With an actively managed fund, you could expect to pay a 1% surcharge, or $5, whereas a passive fund may charge 1/10 of your deposit.
- Shareholder fees. Shareholder fees also come in the form of sales loads, paid by investors for buying or selling fund shares. These are generally tied to funds bought through a brokerage firm, giving the broker commission. You pay a front-end sales load when you first buy shares in a fund. You pay a back-end sales load when you redeem (or sell) shares of the fund.
- No-load funds. No-load funds have no commissions (or sales loads) for transactions. Accounts that don’t charge these fees may charge others, such as redemption fees for selling fund shares (limited to 2% by the SEC and paid to the fund, not broker); exchange fees (for transfers between funds); account fees (often imposed on accounts that don’t meet a financial threshold); and purchase fees (for buying fund shares).
Advantages of mutual funds
Mutual funds are a popular investment choice for their convenience, professional portfolio management, and reasonable pricing.
- Set it and forget it. Stock in a single company is susceptible to downturns. Mutual funds aim to buffer against these whiplashes with diversified assets.
- Professional money management on a budget. If you invest in an actively managed fund, you’re getting a dedicated finance professional without the cost of hiring that person directly.
- Keep things simple. A passively managed mutual fund, like the Vanguard 500 Index Fund, which is designed to align with an index, should be expected to perform more or less like the index itself. That takes some guesswork out of making individual bets on stocks and other securities.
- A cost-effective way to diversify. Mutual funds dip into many asset categories, and for a modest amount of money, you could buy into a mutual fund with stock in Apple, Microsoft, Johnson & Johnson, and more.
Risks of mutual funds
From shaky performance to high fees to poor management, you may want to think twice before investing in a mutual fund for the following reasons.
- You’re out of the driver’s seat. With mutual funds, you cede control of the fund to the manager, whose decisions may not always meet your approval.
- Fees, fees, fees. Actively managed funds generally have higher mutual fund fees, including commissions. You may pay a 1% maintenance fee for an actively managed fund, along with 5% commissions on transactions for shares you buy through a broker. Even funds without sales commissions may have operating or transaction fees.
- Modest gains. A diversified investment portfolio aims to buffer against sharp increases and downturns in the market, but it’s less likely to gain from huge upswings like other assets.
The bottom line
A mutual fund pools resources of multiple investors to buy a bundle of stocks and other securities like bonds. When you buy into a mutual fund, you’re not buying those securities directly, but shares of the fund that buy and sell those securities on your behalf. Mutual funds are often managed by large investment firms.
Funds generally come with maintenance fees, and some charge fees like sales commissions for funds bought and sold through a broker. An actively managed fund is overseen by a professional money manager, whereas a passively managed fund is pegged to an index like the S&P 500.