What Is a Mutual Fund? And How They Work

Investing
Updated: 8th Feb 2021
Written by Kim Pinnelli
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Investing
February 8, 2021
Written by Kim Pinnelli

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If investing with hundreds of other investors, and having someone else make the decision for you sounds ideal, a mutual fund may be your next investment.

Learn all about mutual funds, what you must know, and how to invest in them when you’re ready.

What Is a Mutual Fund?

The name says it all. A mutual fund is a pooling of funds from many investors to buy a combination of assets. Mutual funds are a diversified investment that includes stocks, bonds, and various other assets. A professional fund manager builds and manages the portfolio for you.

Ready Start Investing? Check our guide on how to start investing.

How Do Mutual Funds Work?

When you buy a mutual fund, you invest money in a mutual fund company whose job it is to buy the assets and build the portfolio.

You don’t buy directly into a company like you would if you bought a company’s stock. Instead, you and the other investors share the profits according to your investment.

Mutual funds have goals that the fund manager tries to achieve. You’ll know the fund’s theme and goal before investing in it, so you know if it’s right for you. Some mutual funds invest in global companies, others in dividend stocks or undervalued stocks.

When you buy a mutual fund share, you buy a share of a portfolio, not an individual company’s stock.

Types of Mutual Funds

Mutual funds invest in various assets, some are focused, like investing in a certain type of stocks and others diversify in a variety of assets.

#1. Income Mutual Funds

Income funds provide investors with regular cash flow. They are great for conservative investors, such as retirees. The main investment is in low-risk bonds.

The fund holds the bonds until maturity, but you earn cash flow from the interest. They do trigger a tax liability, so remember that when creating your strategy.

#2. Growth Funds

Growth mutual funds hold growth stocks or companies predicted to have earnings higher than the market.

The shares cost more, but the earnings may be higher too. They are best for aggressive investors who can handle periods of extreme highs and lows.

#3. International/Global Mutual Funds

International mutual funds are a great way to diversify your portfolio. They invest in companies outside of the US. You can invest in different companies worldwide to offset the risk of pooling all your money in one economy.

#4. Balanced Funds

The name says it all. Balanced funds are a balance of assets that offset one another’s risk. Rather than investing in just stocks or just bonds, it diversifies across the board, so you see steady returns rather than riding the wave of one type of asset.

#5. Money Market Funds

Money market funds are fixed-income funds. Managers invest the funds in low-risk, short-term debt. The returns are low, but they are great to diversify a portfolio or protect a portion of your assets, especially if you’re already in retirement.

#6. Bond Funds

Bond funds invest in bonds. Don’t be fooled and assume this means they’re all low risk; there are bad bonds out there too. Do your research to see how well diversified the mutual fund is, looking at each bond individually to know the risk.

#6. Equity Funds

Like investing in individual stocks, equity funds have the greatest risk. You could see incredible returns or incredible losses in the blink of an eye. Pay attention to each fund’s ‘sub’ name, such as growth, income, or sector to see what the fund specializes in.

#7. Specialty Funds

Specialty mutual funds focus on a distinct area of the market. It may be a particular industry or even a particular part of the industry. The narrow focus is great for those with an eagle eye for what they want, but they carry higher risks for the lack of diversification.

Related: Best Online Stock Brokers

Mutual Fund Benefits

  • Professional Management: It’s a hands-off investment. The fund manager makes all buy and sell decisions based on the overall goal of the fund.
  • Affordability: Many funds don’t have a minimum deposit requirement if you commit to a monthly contribution. Some have minimums, though, so read the fine print.
  • Diversification: Diversification is the key to any investment strategy. Doing it yourself is cumbersome and overwhelming. Mutual fund managers automatically do it for you in one fund taking the pressure off you.
  • Geared Towards Passive Investors: Once you invest in the fund, you sit back and watch it perform. You don’t have to make buy/sell decisions, the fund manager does it for you.
  • Relatively Safe: Because mutual funds are well-diversified, most investors consider them safe. Like any investment, there will be ups and downs, but the diversification offsets your risk of a total loss.
  • Transparent: All mutual funds are subject to strict regulations, so all investors know full details before investing.
  • Easy to Invest: Mutual funds are great for beginning investors without a lot to invest. If you commit monthly contributions, you have many options.

Disadvantages of Mutual Funds

  • ROI Varies: Like any investment, there’s no guarantee of return. You’re trusting the fund manager to choose the best of the best, but there’s no guarantee.
  • Fees: Because they’re actively managed, there are a lot of fees, including load fees, sales fees, and management fees. Know all fees included before investing, or you may see profits much lower than you anticipated.
  • Taxes: If you hold mutual funds in a taxable account, you’ll incur tax liabilities for every dividend payment or capital gain.

Mutual Fund Fees Broken Down

Before you look at mutual fund fees, understand the two types of funds – open-end and closed-end:

  • Open-End Funds: Anyone can buy funds. There isn’t a limit to the number of shares a manager can sell.
  • Closed-End Funds: There are a limited number of shares available (like an IPO). No matter the type of mutual fund, you buy, they have fees. Some are lumped into one fee (load fees) and others are separate and vary by fund. Watch out for penalty fees and other ‘excessive fees’ that aren’t included in the expense ratio.
  • Load Funds: This is also known as the sale charge. It’s the initial percentage of investment each investor pays when buying into the fund. They range from 1% – 3% of the fund. This is in addition to the price of the shares.
  • No-Load Funds: Some funds don’t have an upfront commission and are no-load funds. This means the fund company handles everything themselves and does not use a third-party to distribute and manage funds.

Always watch for ‘other’ fees, though, as they can quickly add up.

How Do I buy a Mutual Fund?

Do your research and find the fund that suits your risk tolerance. Make sure you meet the minimum investment requirements, and understand the fees, including early withdrawal fees. Find a broker, online brokers are great, or invest through your 401K, and buy the mutual fund.

Are Mutual Funds Safe?

Mutual funds are as safe as any other investment. There’s always a risk of loss, but that’s why you invest in taking a risk and earning the rewards when it pays off. Mutual funds are SEC-registered and regulated.

Related: ETFs vs Mutual Funds

Why Are Mutual Funds Popular?

Investors love mutual funds for their passive nature. They don’t have to worry about creating a diversified portfolio which requires a lot of legwork and knowledge. They pay a fund manager to do it for them.

Who Are Mutual Funds Best For?

  • Long-Term Investors
  • Young Adults
  • College Students
  • High Schoolers
  • Retirement Investors

Anyone can invest in mutual funds, but passive investors get the most out of it. If you’re a hands-on investor who likes choosing his/her own investments, the lack of control may make you crazy. If choosing your own investments stresses you out, though, mutual funds are a great option.

Related: Index Funds vs Mutual Funds

Examples of Mutual Funds

  • Fidelity Flex Large Cap Growth Fund – This mutual fund invests in common stocks of companies with large market capitalization. The companies usually have above-average growth and include domestic and international companies.
  • Vanguard Short-Term Federal Fund Investor Shares – 80 percent of this mutual fund is invested in short-term, low-risk bonds. Each bond has a maturity of 1 – 4 years.
  • Goldman Sachs International Eq – This mutual fund focuses on long-term growth. Most of the funds are invested in non-US companies with diversification in up to 3 countries.

Bottom Line: What is a Mutual Fund?

A mutual fund is a great way to diversify your investment with little work involved. You purchase the fund directly from the mutual fund company, and the manager oversees its performance and reacts accordingly. If you find the right fund with minimal fees, it can be a great way to diversify your portfolio.

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Kim Pinnelli
Kim Pinnelli
Kim is a personal finance expert with a Bachelor’s degree in Finance from the University of Illinois at Chicago. She has been freelance writing for 13 years for a number of large publications. Kim thoroughly enjoys helping people take charge of their personal finances.