What Are Mutual Funds and How Do They Work?
Mutual funds are pooled investment products that you can buy shares of. They provide automatic diversification for a relatively low price. They are a long-term strategy and are one of the leading retirement savings options in the United States.
Mutual funds create a pooled investment by combining money from a group of investors and are operated by professional money managers. The shares you buy as an individual investor represent your part ownership in the mutual fund and in the income it generates.
Technically named “open-end investment companies,” mutual funds invest in stocks, bonds, debts and other types of securities. The collection of holdings in the mutual fund is called a portfolio.
If the fund’s holdings increase in value over the year, this is considered an unrealized capital gain. It won’t be taxable until an investor sells his or her shares.
However, a mutual fund generally makes a capital gains distribution at the end of each year. The distribution represents the net gains realized by the fund’s managers on asset sales executed throughout the year. This distribution is taxable, along with any distributions of fund earnings.
How Mutual Funds Work
- The mutual fund buys stocks, bonds and other securities.
- The investments produce earnings and capital gains.
- The mutual fund pays out a distribution each year based on the earnings and gains.
- Shareholders can typically choose whether to keep the cash or reinvest the distribution.
Mutual funds can be a key part of your personal finance toolbox and retirement planning strategy.
What Are the Different Types of Mutual Funds?
There are several types of mutual funds, giving investors a wide range of flexibility in how they choose to invest. You should consider several different options to find the best mutual funds to fit your investment objectives.
- Balanced Funds
- Also called asset allocation funds, balanced funds invest in a mix of asset classes including stocks, bonds and money markets. This spreads out the risk across classes.
- Equity Funds
- Equity funds invest primarily in stocks. They may be classified according to their features, such as small-cap, mid-cap or large-cap — cap being short for market cap, or the total value of a company’s shares — indicating the size of the companies they invest in.
- Exchange Traded Funds (EFTs)
- ETFs are not mutual funds but function in a similar way, by offering a diversified collection of assets. While mutual funds can only be sold or traded at the end of a trading day, ETFs can be traded throughout the day.
- Fixed-Income Funds
- A fixed-income mutual fund features securities that pay a fixed-rate of return. These include treasury or other government bonds, debt instruments and corporate bonds.
- Income Funds
- Investing primarily in bonds or other types of debt securities, income funds seek to provide a regular stream of income. Their main purpose is to provide a steady cash flow to investors — typically retirees or conservative investors with low risk tolerance.
- Index Funds
- Index funds seek to tie their returns to the performance of a market index such as the S&P 500. Their investments represent a sector of the economy or the stock market.
- International or Global Funds
- International funds invest primarily in foreign companies or seek to track foreign market indexes. Global funds focus primarily on investment in foreign companies, but may also invest in companies in the United States.
- Money Market Funds
- Money market funds let you invest in a pool of short-term securities that typically provide higher returns than typical banking account interest rates. There are several types of money market funds based on the securities each chooses to invest in.
- Other Mutual Funds
- There are also several types of mutual funds that don’t fit neatly into typical classifications. There are socially responsible or ethical funds that invest only in securities tied to guidelines, beliefs or causes; sector funds that target specific sectors of the economy or market; and regional funds focusing on a particular geographic area of the world.
Examples of Types of Mutual Funds
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Pros and Cons of Mutual Funds
As with any investment, you should consider the pros and cons of mutual funds before investing.
Mutual funds have many advantages that have made them one of the most common investment choices in the United States. They are often a form of “investing for beginners” — and they may widen your understanding of how investments work as a whole.
- Simplicity and Convenience
- Mutual funds are easy to understand and convenient to buy. They are also relatively inexpensive to get into. If you have a 401k or other retirement plan through your employer, you most likely already have access to a mutual fund. But you can also invest directly through mutual funds outside of your retirement accounts.
- Diversification maximizes returns and reduces risk by investing in different companies or industries that react differently to the events that affect the market. Mutual funds invest in a wide range of stocks, bonds and other securities. You get instant diversification when you invest in a mutual fund.
- Professionally Managed Portfolio
- Mutual fund managers handle research into investments and monitor them for you. The funds employ financial professionals who have expertise and experience in investments, giving the investor peace of mind.
- The dividends from your shares of a mutual fund can be reinvested — purchasing more shares to grow your investment.
Pros of Mutual Funds
There are also several disadvantages to consider when investing in mutual funds.
- Some mutual fund managers may abuse the system through excessive replacement, churning or other practices to make the fund’s books look better on paper than in your portfolio.
- No Control Over the Fund
- You have no say in what the fund chooses to invest in — you may not even know all the investments in its portfolio.
- Tax Liability
- You have little control over capital gains taxes when you receive distributions from your mutual fund investments. Talk to your financial advisor or a tax professional about what your tax liability may be when considering a mutual fund investment.
- Trading prices — whether you’re buying or selling — are more limited in mutual funds than with other security investments, as they do not trade throughout the day. Mutual funds may not be the best option if you are looking for more flexibility in stock or other securities trades.
Cons of Mutual Funds
Who Are Mutual Funds Best Suited For?
Mutual funds are best-suited for someone who wants to make a long-term investment.
You need to leave your money in a mutual fund for several years to make it worthwhile. This gives you time to let your investment grow sufficiently.
Other investments — such as certificates of deposit or money market accounts — may be better short-term options if you expect to need your money in as little as three to five years.
Mutual Fund Fees
All mutual funds have fees you have to pay, regardless of how well or poorly the fund performs. But they tend to be lower on passively managed funds than on actively managed mutual funds.
There are several types of fees that you should be aware of when buying a mutual fund. These are typically broken down into shareholder fees and annual operating expenses in the fee table near the front of a mutual fund’s prospectus.
- Account Fee
- Some funds may impose an account fee if your investment value drops below a certain dollar amount or for some other account maintenance terms.
- Advisory or Management Fees
- Investment advisory fees are what you pay to the mutual fund manager and its research staff for managing your investment.
- Distribution Fees
- Also called 12b-1 fees, distribution fees cover advertising, marketing and selling fund shares. This includes paying brokers, printing sales literature and publishing prospectuses.
- Exchange Fees
- Some funds charge exchange fees if you transfer (exchange) to another fund within the same mutual fund group.
- Loads cover sales charges or commissions for brokers, financial planners, investment advisors or other intermediaries who handle your investment purchases and sales.
- Purchase Fees
- You may have to pay a purchase fee each time you buy mutual funds. This may be in addition to a load fee.
- Redemption Fees
- You may have to pay redemption fees if you sell mutual fund shares you have only owned for a short period of time.
Types of Mutual Fund Fees
Who Offers Mutual Funds?
Mutual funds are companies in and of themselves. You can buy mutual funds from the fund itself, from a broker or online. Your employer-based retirement plan also likely offers access to mutual funds.
The largest mutual funds have trillions of dollars in assets under management (AUM), according to Mutual Fund Directory.
10 Largest Mutual Fund Companies Based on AUM — 2022
|Rank by AUM||Company Name||AUM (in Billions)|
|7||State Street Global Advisors||$4,140|
|9||BNY Mellon (Dreyfus)||$2,400|
|10||Amundi Asset Management||$2,260|
The price you pay is the per share value of the fund’s net assets — along with any fees, such as sales loads, charged at the time you purchase.
There are three important steps you should take before buying a mutual fund. These can give you a better understanding of your investment and help you maximize its return.
3 Steps To Take When Buying a Mutual Fund
- Read the prospectus carefully. It contains important information about the mutual fund’s risks, expenses and past performance.
- Understand the risks. Mutual funds are not insured by the government and you can lose money when investing in mutual funds.
- Be aware of fees. Shop around for the lowest fees — all mutual funds charge them and they can eat into the return on your investment.
Once you buy a mutual fund, your shares are redeemable, meaning you can sell your shares back to the mutual fund at any time. Typically, the fund will send you payment within seven days, according to the U.S. Securities and Exchange Commission.