What is a mutual fund?
Instead of purchasing every security in a portfolio yourself, you can purchase shares of the mutual fund. Your investment represents an interest in the fund's overall portfolio.
Mutual funds can make diversification easier because one fund may hold many securities. However, diversification does not mean an investment is risk-free. A fund can decline in value when the investments it owns decline.
How do mutual funds work?
The basic concept is straightforward: investors contribute money to a fund, and the fund invests that money according to a defined strategy.
1. Investors buy fund shares
An investor purchases shares of a mutual fund through an investment account. The investment gives the investor an ownership interest in the fund rather than direct ownership of every individual security held by the portfolio.
2. The fund holds a portfolio
The fund uses its assets to purchase investments that fit its stated objective. For example, a stock fund may invest primarily in company shares, while a bond fund may invest in debt securities.
3. The portfolio changes in value
The value of the mutual fund generally changes as the securities in its portfolio change in value. Income generated by investments may also be distributed to investors according to the fund's policies.
4. Investors can redeem shares
Mutual fund investors generally buy or redeem shares through the fund or an intermediary under the fund's rules. The value used for the transaction is tied to the fund's net asset value, commonly called NAV.
NAV matters: Net asset value is based on the value of a fund's assets minus its liabilities, divided by the applicable number of shares. It helps determine the value of mutual fund shares.
Main types of mutual funds
Mutual funds are not all designed for the same purpose. Their risks, holdings, objectives, and expected behavior can differ substantially.
Stock funds
Invest primarily in stocks. Their value can fluctuate significantly with the stock market and the companies held by the fund.
Bond funds
Invest primarily in bonds and other fixed-income securities. They can be affected by interest rates, credit conditions, and bond prices.
Money market funds
Generally invest in short-term, relatively liquid instruments and are designed around preservation of liquidity and stability.
Balanced funds
Hold a combination of stocks, bonds, and sometimes other assets according to the fund's allocation strategy.
Index funds
Seek to track a particular market index or benchmark rather than relying on a strategy designed primarily around individual security selection.
Target-date funds
Use an asset-allocation strategy that is generally designed around a target year and may become more conservative as that year approaches.
Active vs. index mutual funds
Mutual funds can use either active management or an index-based strategy. Understanding the difference can help you evaluate what you are actually paying for and what the fund is trying to accomplish.
| Feature | Active fund | Index fund |
|---|---|---|
| Primary objective | Uses an active strategy to select or weight investments according to the fund's stated objective. | Generally seeks to track a particular index or benchmark. |
| Portfolio decisions | Managers or a management team make investment decisions within the fund's strategy. | Holdings generally follow the methodology of the tracked index. |
| Costs | May have higher operating expenses, although costs vary by fund. | Often designed to operate with a rules-based approach, but expenses still vary by fund. |
| Performance objective | May seek to outperform a benchmark or achieve another stated objective. | Generally seeks to closely follow the performance of its benchmark, before applicable costs and differences. |
An index fund is not necessarily a separate category from mutual funds. Index funds can be mutual funds, and index strategies can also be used by ETFs. Similarly, some ETFs use active management.
Mutual funds vs. ETFs vs. individual stocks
These investments can all have a place in a portfolio, but they work differently. The right comparison depends on what you are trying to accomplish, how much diversification you want, how you want to trade, and what costs apply.
| Feature | Mutual fund | ETF | Individual stock |
|---|---|---|---|
| Diversification | Can provide exposure to many securities through one fund. | Can provide exposure to a broad or narrow group of investments. | Usually represents ownership in one company. |
| Trading | Bought and redeemed according to mutual fund procedures. | Generally trades throughout the market day like a stock. | Generally trades throughout the market day. |
| Pricing | Transactions are generally based on the fund's NAV. | Market prices can move throughout the trading day. | Market price changes throughout the trading day. |
| Management | Can be actively managed or index-based. | Can be actively managed or index-based. | Investor chooses the individual securities. |
| Potential concentration | Depends on the fund's holdings and strategy. | Depends on the ETF's holdings and strategy. | Can be highly concentrated in one company. |
Mutual fund costs and fees
Investment costs can affect long-term results because money spent on fees is money that is not remaining invested. Always review the actual fee information for the specific fund and share class you are considering.
Expense ratio
The expense ratio represents annual operating expenses as a percentage of fund assets. It is one of the recurring costs investors should compare.
Sales loads
Some mutual funds or share classes may charge sales-related fees when shares are purchased or sold. The structure varies by fund and share class.
Transaction or account fees
Depending on the investment platform and fund, additional transaction or account fees may apply.
Distribution-related fees
Certain funds can have distribution or shareholder-service expenses. Review the fund's fee disclosures rather than assuming every fund has the same costs.
Turnover and tax effects
Portfolio trading can create taxable distributions in taxable accounts. The effect depends on the fund and the investor's account and tax situation.
Do not judge a fund by its share price. A mutual fund with a lower share price is not automatically cheaper or a better value. Compare the fund's costs, holdings, strategy, and other relevant characteristics instead.
Mutual fund risks
A mutual fund can spread exposure across many securities, but it remains an investment. Different funds carry different types and levels of risk.
Market risk
Stock and other market values can decline, reducing the value of the fund.
Interest-rate risk
Bond funds can be affected by changes in interest rates and bond prices.
Credit risk
Bond investments can be affected by changes in an issuer's ability to meet its obligations.
Concentration risk
A fund can still be concentrated in particular sectors, companies, countries, or asset types.
Strategy risk
A fund's investment approach may perform poorly in certain market environments.
Inflation risk
Returns that do not keep pace with rising prices can reduce purchasing power over time.
Liquidity considerations
Some funds may invest in securities that are less liquid than others, which can affect portfolio behavior.
Target-date risk
A target-date fund does not guarantee a particular return or guarantee that your investment will meet your goal.
Diversification can reduce the effect of a single investment performing poorly, but it cannot eliminate broad market losses.
How mutual funds can affect taxes
Mutual fund taxation depends on the type of account, the fund's activities and distributions, and the investor's individual circumstances.
In a taxable investment account, a fund may distribute income or capital gains to shareholders. In some circumstances, an investor can therefore have a tax consequence from a fund distribution even when the investor did not personally sell their fund shares.
Retirement accounts can have different tax rules. Because tax treatment varies by account and situation, investors should review the applicable tax information before making decisions.
Important: Tax treatment is not determined solely by whether an investment is called a mutual fund. The account, distribution, transaction, and investor's circumstances all matter.
How to evaluate a mutual fund
Looking only at a fund's recent return can hide important information. A broader review can help you understand what you are actually investing in.
Mutual fund example
Imagine a broad stock index mutual fund designed to track a large-market benchmark.
One fund can represent many companies
Instead of purchasing shares of hundreds of companies separately, an investor can purchase shares of the mutual fund.
The fund owns the underlying securities according to its investment strategy. The investor owns shares of the fund, rather than directly owning every company in the fund's portfolio.
If the overall portfolio falls in value, the investor's fund shares can also fall. The diversification changes the type of exposure; it does not remove investment risk.
Common mutual fund mistakes
Before investing in a mutual fund
A mutual fund should fit into a broader financial plan, rather than being selected in isolation.
Mutual fund FAQs
What is a mutual fund?
A mutual fund pools money from multiple investors and uses that money to purchase a portfolio of investments such as stocks, bonds, money market instruments, or a combination of assets.
Are mutual funds safe?
Mutual funds are investments and can lose value. The amount and type of risk depend on the securities held by the fund, its strategy, diversification, and market conditions.
Can I lose money in a mutual fund?
Yes. A mutual fund's value can decline when the investments it holds decline in value. Diversification can reduce some individual-security risk but does not eliminate investment losses.
What is a mutual fund expense ratio?
An expense ratio is an annual operating expense expressed as a percentage of a fund's assets. It represents part of the cost of operating and managing the fund.
What is the difference between a mutual fund and an ETF?
Both can provide diversified exposure to investments. Mutual funds and ETFs differ in how shares are bought and sold, how they are priced, and how their expenses and tax characteristics may work.
What is the difference between an active and index mutual fund?
An active fund uses a management strategy involving security selection or portfolio decisions, while an index fund generally seeks to track a specified index or benchmark.
How do mutual funds make money?
Investors can potentially benefit when the securities held by the fund increase in value or generate income. The fund may distribute income or gains to investors, depending on its holdings and policies.
Are mutual funds taxed?
Tax treatment depends on the type of account, fund distributions, transactions, and the investor's circumstances. Taxable accounts can receive taxable distributions from mutual funds.
Do mutual funds pay dividends?
A mutual fund may distribute income it receives from investments, including dividends from stocks or interest from bonds. The amount and timing depend on the fund and its holdings.
Can mutual funds be useful for beginners?
Mutual funds can provide diversified exposure through a single investment, but whether a particular fund fits depends on the investor's goals, time horizon, risk tolerance, account type, costs, and strategy.