Definition... Mutual funds are collective investments managed by professional money managers. They trade on exchanges and provide investors with an accessible way to gain access to a broad mix of assets selected for the fund.
What is a Mutual Fund?
A mutual fund is an investment vehicle that pools money from many investors to purchase a diversified portfolio of stocks, bonds or other securities (according to the fund's stated strategy).
This allows individual investors to invest in a professionally managed portfolio and potentially benefit from economies of scale, while spreading the risk across many investments.
Key Takeaways
- A mutual fund is a portfolio of stocks, bonds or other securities purchased with the combined capital of investors.
- Mutual funds provide individual investors with access to a diversified, professionally managed portfolio.
- Mutual funds are characterized by the types of securities they invest in, their investment objectives and the type of return they require.
- Mutual funds charge annual fees, expense ratios or commissions, which reduce their overall return.
- Many American workers put their retirement funds into mutual funds through employer-sponsored retirement plans, a form of "automatic investing" that builds wealth over the long term with more limited investment risk than other asset options.
Mutual Funds: How Many Funds Is Too Many?
How Mutual Funds Work
A mutual fund is defined as a portfolio of investments funded by all the investors who have purchased shares in the fund. Therefore, when a person buys shares in a mutual fund, he or she receives partial ownership of all the underlying assets owned by the fund. The performance of the fund depends on how its collective assets are performing. When the value of these assets increases, the value of the fund's shares also increases. Conversely, when the value of the assets decreases, the value of the shares also decreases.
The mutual fund manager oversees the portfolio, deciding how to divide the money across sectors, industries, companies, etc., depending on the fund's strategy. Nearly half of the mutual funds held by American households are in index equity funds, whose portfolios include assets from the index and are weighted to reflect the S&P 500 or the Dow Jones Industrial Average (DJIA).
The largest mutual funds are managed by Vanguard and Fidelity. They are also index funds. These generally have limited investment risk, unless the entire market goes down. Still, over the long term, market-linked index funds have gone up, helping meet the investment objectives of many future retirees.
By 2023, more than half of American households will have invested in mutual funds, and collectively they will hold 88% of all mutual fund assets. This represents a significant increase from just a few decades ago, when in 1980, less than 6% of American households invested in mutual funds. Today, most of the retirement savings of middle-income Americans are tied up in these funds.
By setting money aside in a mutual fund, families can access a variety of investments, which can help reduce their risk compared to investing in a single stock or bond. Investors earn a return based on the fund's performance minus any fees or expenses. Mutual funds are often the preferred investment for Middle America, providing professionally managed portfolios of equities, bonds and other asset classes to a large group of middle-income workers.
Most mutual funds are part of large investment companies or fund families, such as Fidelity Investments, Vanguard, T. Rowe Price and Oppenheimer.
How is income calculated for a mutual fund?
Investors typically earn returns from mutual funds in three ways:
Dividend/interest income: Mutual funds distribute dividends on stocks and interest on bonds held in their portfolios. Funds often give investors the option of receiving a check for distributions or reinvesting the proceeds for additional shares in the mutual fund.
Portfolio distributions: If the fund sells securities that have gone up in price, the fund receives capital gains, which most funds pass on to investors through distributions.
Capital gains distributions: When the price of the fund's shares goes up, you can sell your mutual fund shares for a profit in the market.
When researching a mutual fund's returns, you'll typically find a figure for "total return," or the net change in value (either up or down) over a specific period. This includes any interest, dividends, or capital gains earned by the fund during a given period and the change in its market value. In most cases, total returns are given for one-, five- and 10-year periods, as well as from the day the fund opened or the date of inception.
Types of Mutual Funds
There are more than 8,700 mutual funds in the U.S. of several types, most of which fall into four main categories: stock, money market, bond, and target-date funds.
Stock Funds
As the name suggests, this fund invests primarily in equities or stocks. There are several subcategories within this group. Some equity funds are named based on the size of the companies they invest in: small-, medium- or large-sized capitalization firms. Others are named based on their investment approach: aggressive growth, income-oriented, and value. Equity funds are also classified based on whether they invest in U.S. stocks or foreign equities. To understand how these strategies and asset sizes may match up, you can use an equity style box like the example below.
Value funds invest in stocks that their managers consider undervalued, while aiming for growth over the long term when the market recognizes the shares' true value. These companies are characterized by low price-to-earnings (P/E) ratios, low price-to-book ratios and dividend yields. Meanwhile, growth funds look for companies with solid earnings, sales and cash flow growth. These companies typically have high P/E ratios and do not pay dividends.
The compromise between strict value and growth investing is a "blend." These funds invest in a mix of growth and value stocks so that the risk-to-return profile is somewhere in the middle.
Large-cap companies have a market capitalization of more than $10 billion. Market capitalization is arrived at by multiplying the stock price by the number of shares outstanding. Large-cap stocks typically refer to blue-chip firms with recognizable names. Small-cap stocks have a market capitalization of between $250 million and $2 billion. These companies tend to be newer, riskier investments. Mid-cap stocks fill the gap between small- and large-caps.
Financial Industry Regulatory Authority. "Market Cap Explained."
A mutual fund can combine different investment styles and company sizes. For example, a large-cap value fund might include in its portfolio large-cap companies that are in strong financial health but have recently seen their stock prices decline; these would be placed in the upper left quadrant of the style box (large and value). The opposite would be a small-cap growth fund that invests in startup technology companies with high growth prospects. This type of fund is in the bottom right quadrant above (small and growth).
Bond Funds
A mutual fund that produces consistent and minimal returns is part of the fixed income category. These mutual funds focus on investments that pay a fixed rate of return, such as government bonds, corporate bonds, and other debt instruments. The bonds should generate interest income that is passed on to shareholders with limited investment risk.
There are also actively managed funds that look for relatively low-priced bonds to sell at a profit. These mutual funds will likely produce higher returns but are not risk-free. For example, a fund specializing in high-yield junk bonds is much riskier than a fund that invests in government securities.
Because there are so many different types of bonds, bond funds can vary dramatically depending on when and what they invest in, and all bond funds are subject to risks related to changes in interest rates
Index mutual funds
Index mutual funds are designed to replicate the performance of a particular index, such as the S&P 500 or DJIA. This passive strategy requires less research from analysts and advisors, so fewer expenses are passed on to investors through fees, and these funds are designed with cost-sensitive investors in mind.
They often outperform actively managed mutual funds and thus are potentially a rare combination of lower costs and better performance.
Balanced funds
Balanced funds invest in different securities, whether stocks, bonds, money markets or alternative investments. The purpose of these funds, known as asset-allocation funds, is to reduce risk through diversification.
Mutual funds detail their allocation strategies so you know in advance which assets you are indirectly investing in. Some funds follow a dynamic allocation percentage strategy to meet diverse investor objectives. This may include reacting to market conditions, changes in the business cycle, or changing stages of the investor's own life.
The portfolio manager is usually given the freedom to change the proportions of asset classes as needed to maintain the fund's stated strategy.
Money Market Mutual Funds
The money market consists of safe, risk-free, short-term debt instruments, most of which are government Treasury bills. The returns on these are not very high. A typical return is slightly higher than what you would earn on a regular checking or savings account and slightly lower than the average certificate of deposit (CD). Money market mutual funds are often used as a temporary place to hold cash that will be used for future investments or an emergency fund. Despite being lower risk, they are not insured by the Federal Deposit Insurance Corporation (FDIC) like savings accounts or CDs.
Income Funds
The purpose of income funds is to distribute income on a regular basis, and are often viewed as mutual funds for retirement investing. They invest primarily in government and high-quality corporate debt, holding these bonds to maturity to provide an interest stream. While the value of fund holdings may increase, the primary goal is to provide a steady cash flow.
International Mutual Funds
An international mutual fund or foreign fund invests only in assets located outside the investor's home country. However, global funds can invest anywhere around the world. Their volatility depends on where and when the funds are invested. However, these funds can be part of a well-balanced, diversified portfolio because returns from abroad can provide a balance against lower returns at home.
Regional Mutual Funds
Often international in scope, regional mutual funds are investment vehicles that focus on a specific geographic region, such as a country, continent, or group of countries with similar economic characteristics. These funds invest in stocks, bonds, or other securities of companies that are headquartered in or generate a significant portion of their revenue from a targeted region.
Examples of regional mutual funds include Europe-focused mutual funds, which invest in securities from that continent; emerging markets mutual funds, which focus on investments in developing economies around the world; and Latin America-focused mutual funds, which invest in countries such as Brazil, Mexico, and Argentina.
The main advantage of regional mutual funds is that they allow investors to take advantage of the growth potential of specific geographic areas and diversify their portfolios internationally. However, these funds also have unique risks, such as political instability, currency fluctuations, and economic uncertainty, although they depend on the region.
Sector and theme mutual funds
Sector mutual funds aim to profit from the performance of specific sectors of the economy, such as finance, technology or healthcare. Theme funds can operate across sectors. For example, a fund focused on AI might have holdings in firms in healthcare, defense and other sectors that are employing and developing AI beyond the tech industry. Sector or theme funds can have volatility ranging from low to extreme, and their drawback is that in many sectors, stocks tend to rise and fall together.
Socially responsible mutual funds
Socially responsible investing (SRI) or so-called ethical funds invest only in companies and sectors that meet predetermined criteria. For example, some socially responsible funds do not invest in industries such as tobacco, alcoholic beverages, weapons or nuclear power. Sustainable mutual funds invest primarily in green technology such as solar and wind power or recycling.
There are also funds that review environmental, social and governance (ESG) factors when choosing investments. This approach focuses on the company's management practices and whether they lead to environmental and community improvement.
How to Invest in Mutual Funds?
Investing in mutual funds is relatively simple and involves the following steps:
- Before buying shares, you should check with your employer to see if they offer additional mutual fund products, as these may come with matching funds or be more tax-advantaged.
- Make sure you have a brokerage account with sufficient funds and access to buy mutual fund shares.
- Identify mutual funds that match your investment goals for risk, return, fees and minimum investment. Many platforms offer fund screening and research tools.
- Determine how much you want to invest and submit your trade. If you wish, you can set up automatic recurring investments as you wish.
- While these investments are often for the long term, you should still check on the fund's performance from time to time and make adjustments as needed.
- When it’s time to close your position, enter a sell order on your platform.
Mutual Fund Fees
When investing in mutual funds, it's important to understand the fees associated with them, as these costs will significantly impact your investment returns over time. Here are some common mutual fund fees:
Expense ratio: This is an annual fee that covers the fund's operating expenses, including management fees, administrative costs, and marketing expenses. The expense ratio is expressed as a percentage of the fund's average net assets and subtracted from the fund's return. Under pressure from index investing and competition from exchange-traded funds (ETFs), mutual funds have reduced expense ratios by more than half over the past 30 years. In 1996, equity mutual fund investors incurred an expense ratio of 1.04% ($1.04 for every $100 in assets). By 2022, this average had fallen to 0.44%, according to the Investment Company Institute. The fee for bond mutual funds was slightly lower at 0.37%, and hybrid models, which often require more management, had expense fees averaging 0.59%.
Sales charges or loads: Some mutual funds charge sales fees, known as "loads," when you buy or sell shares. Front-end loads are charged when you purchase shares, while back-end loads (or contingent and deferred sales charges) are assessed if you sell your shares before a certain date. Sometimes, however, management firms offer no-load mutual funds, which have no commissions or sales fees.
Redemption fees: Some mutual funds charge a redemption fee if shares are sold within a short period of time (typically 30 to 180 days) after purchase, which the U.S. Securities and Exchange Commission (SEC) limits to 2%.
This fee is designed to discourage short-term trading in these funds for the sake of stability.
Other account fees: Some funds or brokerage firms may charge additional fees for maintaining your account or transactions, particularly if your balance drops below a certain minimum.
Although many mutual funds are "no-load," you can still avoid brokerage fees and commissions by buying funds directly from the mutual fund company rather than going through an intermediary.
Categories of Mutual Fund Shares
If you're trying to reduce your fees, you'll need to look at what kind of mutual fund shares you buy. Traditionally, individual investors buy mutual funds that contain A-shares through a broker. Then, a front-end load of 5% or more, plus management fees and ongoing fees for distributions (also known as 12b-1 fees) will be added. Financial advisors who sell these products may encourage clients to buy higher-load offerings to make commissions. With front-end funds, the investor pays these expenses when buying into the fund.
To address these problems and meet fiduciary-law standards, investment companies have created new share classes, including "level load" C shares, which generally have no front-end load but do have a 12b-1 annual distribution fee of up to 1%.
Funds that charge management and other fees when investors sell their holdings are classified as Class B shares.
How Mutual Fund Shares Are Priced
The value of a mutual fund depends on the performance of the securities it invests in. When you buy units, or shares, of a mutual fund, you receive a portion of its portfolio value. Investing in mutual fund shares is different from investing in stock shares. Unlike stocks, mutual fund shares do not give their holders voting rights. And unlike ETFs, you cannot trade your shares throughout the business day.
Mutual fund share prices come from the net asset value (NAV) per share, sometimes listed on platforms as NAVPS. A fund's NAV is derived by dividing the total value of the securities in the portfolio by the number of shares outstanding.
Mutual fund shares are typically purchased or redeemed at the fund's NAV, which does not fluctuate during market hours but is settled at the end of each business day. The mutual fund's price is also updated at the time of settlement of the NAVPS.
Pros and Cons of Mutual Fund Investing
There are many reasons why mutual funds have been the first choice of retail investors, with most of the money invested in employer-sponsored retirement plans invested in mutual funds. In particular, the SEC has long paid close attention to how these funds are run, as they are vital to many Americans and their retirement.
Advantages of Mutual Fund Investing
Diversification
Diversification, or the mix of investments and assets within a portfolio to reduce risk, is one of the benefits of investing in mutual funds. A diversified portfolio contains securities with different capitalizations and industries and bonds with different maturities and issuers. A mutual fund can achieve diversification faster and more cheaply than buying individual securities.
Easy access
Trading on major stock exchanges, mutual funds can be bought and sold relatively easily, making them highly liquid investments. Also, for certain types of assets, such as foreign equities or exotic commodities, mutual funds are often the most efficient way for individual investors to participate—sometimes even the only way.
Economies of scale
Mutual funds also provide economies of scale. Buying only one security at a time can incur hefty transaction fees. Mutual funds also enable investors to take advantage of dollar-cost averaging, which sets aside a fixed amount of money over time, no matter how the market changes.
Because a mutual fund buys and sells large amounts of securities at once, its transaction costs are lower than those of an individual who pays for securities transactions. A mutual fund can invest in a few assets or take larger positions than a small investor can.
Professional management
A professional investment manager uses research and efficient trading. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to invest and monitor him. Mutual funds require very low investment minimums, offering individual investors a low-cost way to experience and benefit from professional money management.
Transparency
Mutual funds are subject to industry regulations that aim to ensure accountability and fairness for investors. In addition, the constituent securities of each mutual fund can be found on many platforms.
You can research and choose from funds with different management styles and goals. A fund manager may focus on value investing, growth investing, developed markets, emerging markets, income or macroeconomic investing, among many other styles. This diversification enables investors to invest not only in stocks and bonds but also in commodities, foreign assets, and real estate through specialized mutual funds. Mutual funds offer possibilities for foreign and domestic investments that might otherwise be inaccessible.
Mutual fund managers are legally bound to follow the fund's stated mandate and act in the best interest of mutual fund shareholders.
Disadvantages of Mutual Fund Investing
Liquidity, diversification, and professional management all make mutual funds attractive options. However, there are some drawbacks:
No FDIC guarantee
Like many other investments with no guaranteed returns, there is always the possibility that the value of your mutual fund will decline. Equity mutual funds experience price fluctuations along with the stocks in the fund's portfolio. The FDIC does not guarantee mutual fund investments.
Cash Drag
Mutual funds have to keep a large portion of their portfolios in cash to meet share redemptions every day. To maintain liquidity and the ability to accommodate withdrawals, mutual funds generally have to keep a larger portion of their portfolios in cash than other investors. Because this cash does not generate any returns, this is called "cash drag."
High Costs
Fees that reduce your total payout from a mutual fund are assessed regardless of the fund's performance. Not paying attention to fees can hurt you because actively managed funds have transaction costs that add up and increase year after year.
Dilution
Dilution is also the result of a successful fund becoming too big. When new money comes into a fund with a solid track record, the manager may have trouble finding suitable investments to make good use of all the new capital.
The SEC requires that at least 80% of a fund's assets be in the particular types of investments specified by their title.
How the remaining assets are invested is up to the fund manager. However, the categories eligible for 80% of assets can be vague and broad. Some less scrupulous fund managers may manipulate potential investors through their fund titles. For example, a fund focused on Argentine stocks may be sold with a much more broad title such as "International High-Tech Fund."
End-of-Day Trading Only
Mutual funds allow you to request that your shares be converted into cash at any time. However, unlike stocks and ETFs that trade throughout the day, mutual fund redemptions can only occur at the end of the trading day.
Taxes
When the mutual fund manager sells a security, a capital-gains tax is due, which may also be applied to you. ETFs, for example, avoid this through their creation and redemption mechanism. Your taxes can be reduced by investing in tax-sensitive funds or by holding non-tax-sensitive mutual funds in a tax-deferred account, such as a 401(k) or IRA.
Evaluating Mutual Funds
Researching and comparing funds can be more difficult than other securities. Unlike stocks, mutual funds do not give investors the opportunity to compare price-to-earnings (P/E) ratios, sales growth, earnings per share (EPS), or other important data to one another. The mutual fund's NAV can provide some basis for comparison, but given the diversity of portfolios, it can be difficult to compare the proverbial apples to apples, even among funds with similar names or stated objectives. Only index funds that track similar markets are truly comparable.
Be careful with "diversification"
"Diversification"—a play on words that defines the concept—is an investing term used when too much complexity can lead to poor results. Many mutual fund investors overcomplicate matters. That is, they end up buying too many funds that are too similar and, as a result, lose the benefits of diversification.
Mutual Fund Example
The most notable mutual fund includes Fidelity Investments' Magellan Fund (FMAGX). Established in 1963, this fund's investment objective was to generate capital appreciation through investments in common stocks. The height of the fund's success was between 1977 and 1990 when Peter Lynch served as its portfolio manager. During Lynch's tenure, Magellan's assets under management grew from $18 million to $14 billion.
As of March 2024, Fidelity Magellan has approximately $33 billion in assets, managed by Sammy Simnegar since 2019. The S&P 500 is the fund's primary benchmark.
Mutual Funds vs. Index Funds
Index funds are mutual funds that aim to replicate the performance of a market benchmark or index. For example, an S&P 500 index fund tracks that index by holding 500 companies in the same proportions. One of the main goals of an index fund is to minimize costs in order to closely mirror its index.
In contrast, actively managed mutual funds try to beat the market by picking stocks and changing allocations. The fund manager seeks to achieve a return higher than the benchmark through their investment strategy and research.
Index funds deliver market returns at a lower cost, while active mutual funds aim for higher returns through efficient management that often comes at a higher price. When deciding between index or actively managed mutual fund investments, investors should consider cost, time horizon, and risk appetite.
Mutual Funds vs ETFs
Mutual funds and ETFs are pooled investment funds that offer investors a stake in a diversified portfolio. However, there are some key differences.
Most importantly, ETF shares are traded on stock exchanges like regular shares, while mutual fund shares are traded only once daily after the market closes. This means ETFs can be traded anytime during market hours, allowing for greater liquidity, flexibility and real-time pricing. This flexibility means you can short sell them or employ many of the strategies you use for stocks.
Another key difference is pricing and valuation. Like stocks, ETF prices also fluctuate throughout the day according to supply and demand. Meanwhile, mutual funds are priced only at the end of each trading day based on the NAV of the underlying portfolio. This also means that ETFs are likely to have a higher premium/discount to NAV than mutual funds.
ETFs have some tax advantages compared to mutual funds and are often more cost-efficient.
Are mutual funds safer investments?
All investments involve some degree of risk when purchasing securities such as stocks, bonds or mutual funds – and the actual risk of a particular mutual fund will depend on its investment strategy, holdings and manager's ability. Unlike deposits in banks and credit unions, money invested in mutual funds is not FDIC or otherwise insured.
Can I withdraw money from a mutual fund at any time?
Yes. Mutual funds are generally highly liquid investments, meaning you can redeem your shares on any business day. However, it's important to be aware of any potential fees or penalties associated with early withdrawals, such as redemption fees or short-term trading fees, which some funds charge to discourage people from trading in the fund frequently.
There can be tax implications when you withdraw money, especially if the value of the investment has increased, meaning you'll have to pay taxes on capital gains.
Do you really make money from mutual funds?
Yes, many people make money for retirement and other savings goals through capital gains distributions, dividends and interest income.
As the value of the securities in a mutual fund's portfolio increases, the value of the fund's shares typically increases, leading to capital gains. In addition, many mutual funds pay dividends from the income earned on securities the fund holds. If the fund holds bonds, it will earn interest on them.
However, returns are not guaranteed and a mutual fund's performance depends on market conditions, the fund's management, the assets it holds and its investment strategy.
What are the risks of mutual funds?
Mutual funds have a number of investment risks depending on the assets they hold, including market, interest rate and management risks. Market risk arises from a potential decline in the value of securities within the fund. Interest rate risk affects funds that hold bonds and other fixed-income securities, as a rise in interest rates can cause bond prices to decline.
Management risk is associated with the performance of the fund's management team. You are putting your money in their hands, and poor investment decisions will negatively impact your returns. Before investing, it is important for investors to carefully review the fund's prospectus and consider their own risk tolerance and investment objectives.
What is a target date mutual fund?
When investing in a 401(k) or other retirement savings account, target-date or life cycle funds are popular. Choosing a fund that grows as you move toward retirement, such as a hypothetical Fund X 2050 (which would target a 2050 retirement year), means investing in a mutual fund that rebalances its risk profile and automatically shifts to a more conservative approach as you approach the target date.
The Bottom Line
Mutual funds are versatile and accessible to those who want to diversify their portfolios. These funds pool money from investors for stocks, bonds, real estate, derivatives and other securities – all managed for you. Key benefits include access to a diversified, professionally managed portfolio and choosing from funds that suit different objectives and risk tolerances. However, mutual funds do have fees and expenses, including annual fees, expense ratios or commissions, which will help determine your overall return.
Investors can choose from several types of mutual funds, such as stock, bond, money market, index and target-date funds, each of which has its own investment focus and strategy. Returns on mutual funds come from distributions of income from dividends or interest and from selling fund securities at a profit.
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