• A mutual fund is a basket of mixed investments such as stocks, bonds, cash, and other assets.
  • Mutual funds offer you a convenient way to diversify your holdings, reduce portfolio volatility, and benefit from professional fund management.
  • Because of the assets they hold, mutual funds are subject to market risk. Familiarize yourself with the fund’s investment objectives and expenses before acquiring any shares.

What if instead of buying just one stock or bond, you could invest in dozens or even hundreds of them at once? This is possible using a financial instrument called a mutual fund.

Here’s what you need to know about mutual funds and how they work.

A mutual fund is an investment representing a pooled group of assets of various types of stocks, bonds, commodities, and even other mutual funds. By holding a diverse range of carefully selected securities, the fund may have lower volatility and more consistent performance than you might experience with a handful of individual stocks or bonds.

Mutual funds rely on the capital from thousands of investors to assemble their portfolio. As the name suggests, each shareholder “mutually” benefits from the performance of the fund as the performance of its underlying assets improves.

Mutual funds can be either actively or passively managed.

An actively managed mutual fund will have a professional fund manager who decides which assets the fund will hold.

A passively managed mutual fund will simply replicate an already established benchmark (such as the S&P 500).

Either way, as an investor, this may be a great way to reduce the guesswork of deciding which securities to hold.

How Do Mutual Funds Work?

Mutual funds are very common and widely used financial instruments. Since their inception in 1924, investors have been utilizing them to add instant diversification of their portfolios and build long-term wealth (such as saving for retirement).

Here’s a brief overview of how they work.

Buying Mutual Funds

Similar to stocks, mutual funds are sold in units called shares. Each share represents a slice of ownership of the fund, not the actual individual investments held within.

If you have a tax-advantaged retirement account such as a 401(k), then there’s a good chance that you may already own some mutual funds. Approximately 65% of today’s 401(k) plans rely on mutual funds, thanks in part to their ease of use and long-term stability.[1]

You can also purchase mutual fund shares through a taxable brokerage account or investment service provider. Depending on where you purchase shares, there may be some minimum amounts required to start investing.

Mutual Fund Net Asset Value

Like other assets, a mutual fund's share price or net asset value (NAV) will fluctuate daily. NAV represents the fund’s total assets minus its liabilities divided by the number of shares outstanding.[2] To put it simply, as the value of the underlying assets goes up and down, so too may the overall value of the portfolio.

Unlike a stock whose price is determined by market supply and demand, mutual fund share prices only change once per day. This is done when the NAV is recalculated after the markets have closed, and the final price of the assets can be assessed.

Holding Mutual Funds

You can earn money from mutual funds in two ways:

Price appreciation – As the NAV increases over time, you may have the opportunity to sell your mutual fund shares for more than what you originally paid for them.

Distributions – Many mutual funds regularly send capital gains and dividends to their shareholders.

Selling Mutual Funds

Many mutual funds are very liquid and can be traded at the discretion of the investor. However, they are typically best utilized as long-term investments. Note that some funds also have a required holding period (such as one year) where a fee may be imposed if shares are sold too early.   

Types of Mutual Funds

Mutual funds come in all shapes and sizes. Here are a few of the main categories offered by the industry.

Equity Funds

Equity funds focus on stocks. These funds are generally characterized by their market capitalization and investment prospects of the companies they invest in.

Market capitalization is the total value of the company’s outstanding shares. This can be described as follows:[3]

  • Large cap stocks – $10 billion or more
  • Mid cap stocks – $2 billion to $10 billion
  • Small cap stocks – $300 million to $2 billion

Investment prospects refer to how those companies are expected to perform based on the type of business they conduct. For example,

  • Value stocks – Businesses with good fundamentals that may be currently underperforming the market and are currently viewed as a good buying opportunity.
  • Growth stocks – Businesses with high aspirations to outperform the market (such as companies with new or emerging technologies).

Fixed Income Funds

Fixed income funds invest in long-term, medium-term, and short-term debt instruments, including bonds, government securities, and treasury bills. Their goal is typically to produce a steady stream of income while also minimizing volatility.

Money Market Funds

Money market funds invest in short-term debt such as treasury bills, certificates of deposit, and commercial paper. Investors rely on these funds for capital preservation and modest income generation.

Asset Allocation Funds

Asset allocation funds combine multiple types of securities to achieve specific investment goals. For example, a fund with a classic 60/40 asset allocation might invest in 60% large-cap stocks and 40% treasury bonds.

Target Date Funds

Target date funds are intended to prepare their shareholders for retirement by gradually adjusting their asset allocation over time. For example, a 2050 target date fund might currently hold a large majority of growth stocks. However, as the year 2050 approaches, those stocks may be replaced with more conservative assets such as bonds.

Index Funds

Index funds aim to replicate the performance of a major benchmark such as the S&P 500 or NASDAQ. The goal of these types of funds is to passively produce returns consistent with the average performance of the overall market.

Sector-Specific Funds

Sector-specific funds invest in specific types of companies, organizations, or causes. For example, ESG (environmental, social, and governance) funds choose companies whose values and principles align with sustainability and responsible business practices

Investing in Mutual Funds: What To Consider

Like any investment, it’s important to understand what you’re purchasing and how it might help you achieve your financial goals.

Expense Ratios and Management Fees

All mutual funds carry an expense ratio to cover their operational costs, like management and administrative fees. This fee is often expressed as a percentage and represents the total cost you’ll pay each year.

Though not as common, some funds also charge front and/or back-end loads — fees for buying and selling shares of the fund. There may also be redemption fees.

Fund Performance and Historical Returns

Reviewing the history of any mutual fund may give you some insight into how it may behave going forward. Though past performance is never a guarantee of the future, this information may reveal how a fund did during a previous recession, or its volatility compared to a benchmark.

Investment Objectives and Risk Tolerance

Never choose a fund based on historical returns alone. Consider the composition of the fund and its investment objectives as well. For example, if you’re someone who’s risk-averse, then choosing funds that have a more conservative investment strategy may be better aligned with your liking.

Advantages and Disadvantages of Mutual Funds

Before buying shares of a mutual fund, investors should consider the following pros and cons.

Benefits

  • Diversification – By design, mutual funds invest in a large basket of securities. This helps reduce risk, as the gains from some assets offset the losses from others.
  • Convenience – Mutual funds provide a practical way to diversify across the market and maintain good asset allocation. They are also well-suited for repeat contributions, such as saving for retirement.   
  • Liquidity– Many funds can be bought and sold relatively quickly. This gives investors the opportunity to change their asset allocation or unload funds when cash is needed (such as for an emergency).
  • Professional Management – Actively managed mutual funds give the chance to benefit from the decisions of professional fund managers who determine what to invest in and monitor their performance.
  • Transparency – Publicly available funds are required to disclose their holdings and performance. This information can generally be found in a periodic publication called the prospectus.

Potential Drawbacks

  • Market Risks – Since mutual funds are a basket of assets, the value will be directly tied to their underlying performance. This means that if the markets are down, the funds’ value will also likely decrease.
  • Fees – Expense ratios, front-end/back-end loads, and other fees may eat into the earnings of mutual funds. As an investor, you’ll want to take note of what these values are and if they’re worth the added cost.
  • Tax Complexity – Because mutual funds regularly return capital gains to their shareholders, those held in taxable accounts usually must be reported on your annual tax return. In addition, there may be other atypical tax reporting depending on the type of assets held by the fund (such as capital gains and dividends from foreign companies).
  • Lock-In Periods – You may have to hold some funds for a certain length of time or pay an early redemption fee.

Final Thoughts

Whether saving for retirement or other future goals, mutual funds are a practical way to invest. They’re easy to trade and provide you with a convenient way to benefit from professional fund management or the performance of a broad market index.

However, because the assets they hold are subject to market risk, so are the mutual funds themselves. Therefore, you’ll want to review funds’ objectives and choose ones that align with your personal investment goals.