Understanding Mutual Funds and How They Work

A mutual fund is a financial vehicle that allows investors to pool their money in a professionally managed investment fund. Investing in mutual funds can help you meet your financial goals without having to dive deeply into individual investments.

That said, there’s still a lot investors need to know about mutual funds. This article will cover how mutual funds work, the different types of mutual funds available, and the pros and cons of investing in mutual funds.

What are mutual funds?

Mutual funds pool money from investors to collectively invest in a group of securities. Professional money managers control the investments, optimizing the portfolio to meet the fund’s objectives. Investors can find those objectives in the fund prospectus.

Depending on the fund, the manager will invest in stocks, bonds, money market instruments, alternative assets, or some combination of those. Investments may be concentrated in a specific sector of the markets, or they may cover a wide breadth of the market.

Each investor in a mutual fund has the right to claim a portion of the fund’s returns relative to the amount invested. This is easily achieved by apportioning shares to each investor.

Some mutual funds, called open-end funds, can create new shares as funds flow into the pool. They retire shares as investors look to cash out. These funds are priced based on their net asset value, or NAV. The NAV is simply the sum of all the assets in the mutual fund minus any liabilities. To find the share price, you divide the NAV by the number of shares. This calculation is done once per day after the market closes.

To buy shares of an open-end fund, investors pay the mutual fund directly. This differs from ETFs, or exchange-traded funds, which are bought and sold through stock exchanges.

Others, called closed-end funds, have a fixed number of shares. The shares may trade hands through an exchange, but the price isn’t fully reflected by the NAV. Supply and demand will also determine the price of each share. If a lot of investors want into the fund, they may have to pay more than the fund’s current NAV.

Understanding how mutual funds work

Once a fund is established, having pooled money from its investors, the portfolio manager gets to work investing the capital. He or she will buy securities based on the objectives laid out in the fund prospectus.

Those objectives fall into two broad categories. In one category, the fund manager is tasked with outperforming a benchmark index. They will actively buy and sell securities throughout the year to produce better returns for the fund investors than the overall market. These are called actively managed mutual funds.

In the other category, a fund manager is tasked with mimicking the returns of a benchmark index as closely as possible. They might do so by proportionally buying every security in the index in the fund’s portfolio. Or they may selectively sample securities from the index, giving the portfolio an approximation of the index’s overall composition. These are called passively managed funds, or index funds.

The fees and costs associated with mutual funds vary widely, but actively managed funds generally have much higher fees than index funds.

There are two types of fees you might pay when investing in mutual funds: shareholder fees and operating expenses. Shareholder fees are one-time expenses you’ll pay when buying or selling shares. Operating expenses are ongoing fees for holding shares of the mutual fund.

The types of shareholder fees you might encounter include:

• Purchase fee: A fee paid upon purchasing shares of a mutual fund.
• Redemption fee: Commonly charged if you don’t hold your shares for a minimum period.
• Exchange fee: A fee to switch shares from one fund to another within the same financial institution.
• Account fees: A fee to maintain your account at a financial institution, potentially charged when you fall below a minimum account balance.

Another shareholder-type fee for investors to be wary of is the load, or a commission paid to the broker who sold you the mutual fund. It can come up front (front-loaded), when you redeem your shares for cash (back-loaded), or on an annual basis. You should always look for no-load mutual funds.

The types of operating expenses spread across mutual fund investors include:

• Management fees: The fee used to pay the fund manager.
• 12b-1 fees: Fees to cover the marketing and selling of mutual funds. The Securities and Exchange Commission (SEC) limits these fees to 1% of assets annually.
• Miscellaneous: These cover anything else the mutual fund company might need, such as legal fees and administrative expenses.

All of these operating expenses are typically wrapped up in a nice little package for investors and expressed as an expense ratio. The expense ratio tells investors what percentage of their investment every year will go toward paying fees.

Actively managed mutual funds typically have an expense ratio between 0.5% and 1%, with some specialized funds charging much more. Passive index funds can charge much lower fees, going as low as 0% in some cases.

Types of mutual funds

There are lots of different types of mutual funds, but they can be categorized into four main types: stock funds, bond funds, money market funds, and target date funds.

Stock funds

Stock funds invest primarily in equities, but they can vary widely in the types of equities chosen for the fund portfolio.

Some stock funds may focus exclusively on U.S. companies, while others focus exclusively on foreign companies or companies in specific countries or regions. They may also focus on specific sectors, such as technology or energy.

Stock funds are usually categorized by their holdings’ market capitalization (large-cap, mid-cap, small-cap) and the investment factor (value stocks vs. growth stocks).

Putting it all together, you may be able to find a mutual fund that invests in mid-cap technology growth stocks based in the U.S. On the other hand, you could find a much broader stock fund that invests in large-cap stocks all around the world.

Bond funds

A bond fund invests in debt issued by companies and governments to generate both capital gains and interest income for investors. The types of bonds in a bond fund can vary from low-risk government bonds to high-risk junk bonds from companies with very poor credit ratings.

Bond funds rarely hold their bonds until maturity. Instead, the manager will buy and sell securities in an effort to keep the average maturity date in line with the goal outlined in the fund’s prospectus. The prospectus may also detail the types of bonds the manager will buy.

You could buy a fund that tracks a broad bond index or one hyper-focused on buying undervalued corporate junk bonds.

Money market funds

A money market fund invests in relatively safe financial instruments. The goal is principal preservation, but typical returns don’t exceed those that investors could earn from a savings account or certificate of deposit (CD).

Money market funds usually invest in short-term government debt, such as U.S. Treasury bills or municipal bonds near maturity. The latter could result in tax-free interest payments.

Target date funds

A target date fund is a fund of funds. That means the portfolio consists of multiple mutual funds instead of individual securities.

The goal of a target date fund is to provide investors with a portfolio of stocks, bonds, and other assets that offer an appropriate risk profile based on a target retirement date. Each fund family usually provides target dates every five years (e.g., 2020, 2025, 2030, etc.).

As the fund approaches the target date, the portfolio asset allocation becomes more conservative. It becomes increasingly conservative as it moves past the target date with a terminal allocation achieved at some point well after the target date. The prospectus will lay out the “glide path” for the fund, which details how the asset allocation will change over time.

Target date funds can be a great set-it-and-forget approach to reach retirement.

Pros and cons of investing in mutual funds

Like most financial choices, there are pluses and minuses to investing in mutual funds.

Pros

• Instant diversification: When you invest in a mutual fund, you are buying a small share of a diversified portfolio. Diversifying your investments can help prevent any single investment’s failure or success from having a major impact on your portfolio, leading to more steady returns.
• Professional management: Behind every actively managed mutual fund is a portfolio manager. This is a highly trained person with expertise in the fund’s area of investments. It’s their job to manage the portfolio, giving them time to analyze and review investment decisions.
• Simplicity: Investing in a mutual fund is much simpler than building a diversified portfolio all on your own. And, if you buy a target-date fund, it’ll manage your asset allocation for you. It doesn’t get any simpler than that.

Cons

• Fees: The biggest thing working against mutual funds, particularly actively managed mutual funds, is the fees. Hefty fees can cut into your returns. Although 1% might sound like a small price to pay for all the benefits of a mutual fund, the hit on your returns could be substantial in the long run. Passive funds generally have very low fees, making them much more appealing.
• Limited control: When you outsource your capital to a mutual fund portfolio manager, you’re giving up control. The portfolio manager may perform transactions with tax consequences out of your control. What’s more, most funds have to hold a certain amount of cash to pay out investors who are redeeming shares. That cash will drag down the portfolio’s overall returns.
• Hard to evaluate: It’s hard to evaluate a mutual fund. You can look at its past performance, but, as they say, it’s no indication of future success. You can compare expense ratios with similar funds to see how the fees compare. But when it comes down to it, a mutual fund is simply a bet on the fund company and the managers. That said, there are ways to evaluate index funds based on tracking error and expense ratios.

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The bottom line

Mutual funds can be a great way for investors to gain exposure to the stock, bond, and money markets, or specific pieces of the market. Understanding how a mutual fund works can help you select the fund or funds that work best for you. The biggest thing to be mindful of, though, are the fees you’ll incur when you buy shares in a mutual fund. As long as you can keep the fees low, a mutual fund could be a great choice for your portfolio.