What are mutual funds?

Last updated on April 28, 2023, and last reviewed by an expert on February 13, 2022.

Amutual fund is an investment vehicle that allows individuals to invest their money along with other investors. These funds invest in a collection of securities such as stocks, bonds and money market funds. Most mutual funds invest in a large number of securities, allowing investors to diversify their portfolios at a low cost.

Historically, personal investment advisors have tended to work mainly with those who have large amounts of money to invest. Plus, maintaining a diversified portfolio can be unrealistic for most investors to do on their own. Mutual funds look to solve these problems and more.

While mutual funds face fierce competition for investors’ dollars in the form of low-cost index funds and exchange-traded funds (ETFs), they still remain quite popular. Here we’ll discuss how mutual funds work, their pros and cons and answer some key questions to help you decide if these types of investments make sense for your portfolio.

How mutual funds work

A mutual fund is a type of pooled investment fund in which many people own shares. Mutual funds invest in many different companies; some even invest in the entire stock market. However, when you buy shares in a mutual fund, you don’t invest in those companies directly since you own shares in the fund, not in the companies the fund selects.

For example, imagine you invest in a tech-heavy mutual fund. That mutual fund pools the money from all its investors and invests in a number of companies. Therefore, while the fund likely invests in companies such as Amazon and Microsoft, you don’t own shares in those companies. Instead, you simply own shares in the mutual fund.

The share price fluctuates based on the net asset value (NAV) of all of the mutual fund’s assets. NAV is calculated by dividing the total value of a mutual fund’s assets (less liabilities) by the total number of shares outstanding. Thus, changes in the share price don’t reflect fluctuations in the value of a single company, but instead they reflect the net change in all of the companies in which the fund invests.

You can buy shares in a mutual fund from whichever brokerage you prefer. However, employer-sponsored retirement plans largely invest in mutual funds, so you may be invested in them without even realizing it.

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Unlike ETFs, mutual funds can only be traded once per day, after the market closes at 4 p.m. eastern. Because of this, the price of mutual funds doesn’t change throughout the day; it only changes once the NAV settles after market close.

Types of mutual funds

Mutual funds come in a variety of forms. Investors have various goals; thus, different mutual funds invest in different types of securities. Here, we will cover some of those most common types of mutual funds.

Equity funds

Equity funds are the most popular form of mutual fund. As their name implies, these funds invest in equities, which is another name for stocks. Given that there are thousands of publicly-traded companies in the US, this is also a very broad category. Within equity funds are small-cap funds, large-cap funds, value funds, growth funds, and more.

Index funds

Rather than try to beat the performance of the overall market, index funds aim to simply match the performance of a given index, such as the S&P 500. This strategy requires much less research and analysis than funds that attempt to beat the market, leading to lower fees. Those lower fees have made these funds increasingly popular over the past several years.

Money market funds

Money market funds are short-term investment vehicles that usually invest in much safer securities than equity funds and index funds. These funds won’t earn a substantial return, but there is little risk of losing money. Many brokerages park uninvested cash in safe money market funds such as government bonds.

Fixed-income funds

Fixed-income funds invest in government bonds, corporate bonds and other securities that pay a set rate of return. Typically, they are actively-managed and their portfolios can change frequently. Although they pay a set rate of return, some bonds can have high levels of risk, which can hurt returns.

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Balanced funds

Balanced funds invest in a number of different securities, including stocks, bonds, and money market funds. They aim to reduce risk by providing exposure to a variety of asset classes. In some cases, these funds may have a specific asset allocation allowing investors to select investments that align with their goals.

Pros and cons of mutual funds

Mutual funds come with their share of pros and cons. Let’s take a look at both.

Pros

Invest in a large number of securities for diversification
Low minimum investment compared to personal investment advisors
Professional management
Relatively liquid

Cons

Fees can be high, hindering returns
May have a large cash position
Lack transparency
Can be complex and difficult to compare to other mutual funds

Mutual funds and taxes

Fund managers pass on earnings to investors in the form of distributions, mainly at the end of the year. As the investor, it is your responsibility to report capital gains distributions on your tax return and pay the appropriate taxes. Even if you reinvest your dividends, you are still required to pay taxes on them as they are taxed as income.

If you are responsible for taxes when tax time comes, the fund manager should issue you IRS Form 1099-DIV. One way to reduce your tax liability is to hold mutual funds in a tax-deferred investment vehicle, such as a 401(k) or IRA.

Mutual funds vs. ETFs

ETFs often work much like mutual funds, but they have some key differences. These securities track an index or other asset and can be bought and sold on exchanges like stocks. Because of this, they can also be traded throughout the day, and their price fluctuates accordingly. Fees are often lower for ETFs than for mutual funds, making them widely popular.

Both mutual funds and ETFs hold a selection of stocks and/or bonds. You may also see a mutual fund or ETF that invests in commodities or cryptocurrency, but both invest in some kind of security or asset. In addition, they are subject to similar regulations.

However, mutual funds are typically actively managed and only trade once per day, after market close. Their fees can be high in some cases, too.

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On the other hand, ETFs trade like stocks on an exchange. As a result, they can be traded throughout the day. They are not usually actively managed and thus tend to have lower fees.

Employer-sponsored retirement plans often invest in mutual funds, while ETFs tend to be held more often by investors in an individual retirement account (IRA) or taxable account.

Who should invest in mutual funds?

Mutual funds can make sense for many investors at different points in their investing journey. If you’re just starting out, mutual funds offer you access to a broadly diversified portfolio for a relatively low cost. Even more experienced investors can benefit from this, as well as choosing funds that invest in a specific sector that you think is poised for growth.

Remember that mutual funds are only as good as the assets the fund invests in. If a fund invests in stocks that perform poorly, the fund will lag right along with them. Make sure you understand how a fund invests before committing any money.

Mutual fund fees

You’ll want to watch out for the fees mutual funds may charge to avoid having them eat into your investment returns. Just a 1 percent annual fee can have a big impact on your investment returns over a long time period and could cause you to fall short of your investment goals.

Mutual funds include information on their fees in the fund’s prospectus, which can usually be found on the investment manager’s website. Here you’ll find information about the various operating expenses a fund charges such as a management fee, which pays for the fund’s manager and investment advisor, as well as legal, accounting and other administrative fees. You may also come across 12b-1 fees, which pay for the costs related to marketing and selling the fund. All these fees are captured in a fund’s expense ratio, which is shown as a percentage of the fund’s net assets and calculated annually. This expense reduces your investment return each year.

You might also see something called a “load,” which is a commission paid to brokers at the time shares are purchased in the fund. The commission is usually calculated as a percentage of your total investment. Funds that don’t charge this commission are known as “no-load” funds.

Mutual fund classes

Mutual funds are sold in different share classes, with the main difference between the classes being the types of fees they charge. Here’s an overview of the key mutual fund classes.

Class A

Class A shares will typically come with a front-end sales load, but will have lower annual expenses, such as the 12b-1 fee, than other mutual fund classes. Some funds will lower the sales load as the amount invested increases.

Class B

Class B shares typically don’t come with a front-end sales load, but may have one on the back end, as well as a 12b-1 fee and other annual expenses. The most common type of back-end sales load is the contingent deferred sales load, which typically decreases the longer an investor holds the shares.

Class C

Class C shares can come with a sales load on either the front or back end, but it’s typically less than the amount for Class A or B shares. Unlike the B shares, the back-end load won’t decrease over time for Class C shares, which also carry higher annual expenses than A or B shares.

Class I

Class I shares will usually have lower fees than the A, B or C share classes, but are only available to institutional investors making large investments. Retail investors might be able to purchase Class I shares through an employer-sponsored retirement plan.

Clean shares

Launched in 2017, clean shares were created to increase transparency for mutual fund investors about the fees they might pay. This class of shares has no front-end sales charge, deferred sales charge or other fee related to sales or distribution of the fund. Clean shares may still come with annual operating expenses.

The bottom line

A mutual fund is a type of investment consisting of a combination of stocks, bonds, and other securities. They can invest in more than one type of security or in just stocks or bonds, for example.

The benefits of mutual funds include professional management and built-in diversification. However, mutual fund fees can be high in some cases, and they can only be traded at market close.