What Is a Mutual Fund?
A mutual fund is an investment company that pools money from multiple investors and uses the combined money to purchase a portfolio of investments.
Depending on the fund's objective, that portfolio may contain stocks, bonds, short-term debt instruments, money-market investments, or other securities and assets.
When you purchase shares of a mutual fund, you own a portion of the fund's portfolio. You do not normally select each individual security yourself. Instead, the fund follows its stated investment strategy.
The SEC's Investor.gov explains that mutual funds are registered investment companies and that the portfolio is managed according to the fund's stated objective and strategy.
How Do Mutual Funds Work?
The basic structure is straightforward:
- Investors contribute money. Investors purchase shares of a mutual fund through the fund company, brokerage, or another investment intermediary.
- The fund pools the money. The combined investor money becomes part of the fund's assets.
- The portfolio is invested. The fund invests according to its stated strategy, such as tracking an index or selecting securities through active management.
- The portfolio value changes. As the underlying investments change in value, the value of the mutual fund's portfolio changes.
- Investors receive their share of the results. Investors may receive distributions and can gain or lose money when the value of their fund shares changes.
What Is Mutual Fund NAV?
NAV stands for net asset value. It represents the value of a mutual fund's assets after liabilities are deducted, divided by the number of outstanding shares.
Unlike a stock that trades continuously during market hours, a traditional mutual fund generally calculates its NAV once each business day after the market closes.
The actual calculation depends on the fund's assets, liabilities, share count, and valuation procedures.
How Do Investors Make Money From Mutual Funds?
A mutual fund investment can produce returns in several ways.
1. Income distributions
Funds may receive dividends from stocks or interest from bonds and other investments. The fund can distribute applicable income to shareholders.
2. Capital gains distributions
A fund may sell securities for more than their purchase price. Realized gains can contribute to capital gains distributions to shareholders, subject to the fund's accounting and tax requirements.
3. Increase in NAV
If the market value of the fund's portfolio rises, the fund's NAV can increase. An investor who later sells shares for more than the purchase price may realize a capital gain.
Distributions may also be reinvested to purchase additional shares, depending on the account and fund settings.
Types of Mutual Funds
Mutual funds can be organized into many categories based on what they invest in and how they are managed.
Stock mutual funds
Stock funds primarily invest in equities. Their portfolios may focus on broad markets, specific company sizes, sectors, regions, or other characteristics.
Bond mutual funds
Bond funds primarily invest in debt securities. Different bond funds can have very different interest-rate, credit, duration, and volatility characteristics.
Money market mutual funds
Money market funds invest primarily in liquid, short-term debt securities, cash, and cash equivalents. They are subject to investment risks and should not automatically be treated as equivalent to a bank savings account.
Target-date mutual funds
Target-date funds are designed around a particular future date, commonly a retirement year. They typically hold a mixture of investments and may gradually change their asset allocation as the target date approaches.
Balanced or allocation funds
These funds generally combine multiple asset classes, such as stocks and bonds, according to a stated allocation strategy.
International and global funds
These funds invest in securities outside the investor's home market or across multiple countries. International exposure can introduce additional currency, political, and country-specific risks.
Index Funds vs. Actively Managed Mutual Funds
Two major mutual fund management approaches are index investing and active management.
| Feature | Index Mutual Fund | Actively Managed Mutual Fund |
|---|---|---|
| Objective | Generally seeks to track a selected index. | Seeks to achieve a stated objective through manager-selected investments. |
| Portfolio decisions | Primarily determined by the fund's index methodology. | Portfolio managers make investment decisions according to the fund's strategy. |
| Trading | Usually changes as the tracked index changes. | Managers may buy and sell securities as part of the strategy. |
| Costs | Can be relatively low, but costs vary by fund. | Costs vary and may be higher depending on management and fund structure. |
An index fund is not automatically identical to every other index fund. Different funds can track different indexes, use different methods, and have different costs and tracking results.
Mutual Funds vs. ETFs
Mutual funds and exchange-traded funds (ETFs) can both pool investor money into diversified portfolios. However, the way their shares are traded and priced differs.
| Feature | Mutual Funds | ETFs |
|---|---|---|
| Trading | Generally bought or redeemed through the fund at the next calculated NAV. | Shares trade on an exchange during market hours. |
| Pricing | Generally based on the next calculated NAV. | Market price can change throughout the trading day. |
| Intraday trading | Generally no. | Yes. |
| Portfolio structure | Can contain stocks, bonds, and other investments. | Can contain stocks, bonds, and other investments. |
| Costs | Expense ratios and potentially other fees. | Expense ratios plus potential trading costs and bid-ask spreads. |
The appropriate comparison depends on the particular funds being considered. Two products can have similar objectives but different costs, tax characteristics, holdings, and trading structures.
Mutual Funds vs. Individual Stocks
Buying an individual stock means purchasing an ownership interest in a particular company. Buying a mutual fund gives you exposure to the portfolio held by the fund.
For example, purchasing one company's stock concentrates your investment in that company. A mutual fund may own dozens, hundreds, or potentially thousands of securities, depending on its strategy.
Diversification can reduce the effect that one individual investment has on a portfolio, but diversification does not eliminate market risk.
Mutual Fund Fees and Costs
Fees can reduce the amount of money that remains invested and can therefore affect long-term results.
Expense ratio
The expense ratio represents ongoing operating expenses expressed as a percentage of fund assets. These expenses are generally reflected in the fund's returns and NAV rather than being billed as a separate monthly invoice.
Sales charges or loads
Some mutual funds or share classes can have sales charges when shares are purchased or sold. Other funds may have no sales load.
Redemption fees
Certain funds can impose fees associated with selling shares under specific circumstances. Review the fund's current documents before investing.
Account and transaction costs
Depending on where a fund is held and how it is purchased, an intermediary may charge additional account or transaction fees.
What Are Mutual Fund Share Classes?
Some mutual funds offer multiple share classes. The classes can hold the same underlying investments and follow the same objective, while using different fee structures.
For example, one share class might have a particular sales charge, while another may use a different ongoing expense structure.
Always examine the actual share class you are considering rather than assuming that every version of a fund has identical costs.
How Are Mutual Funds Taxed?
Tax treatment depends on the type of account, the fund, the distributions you receive, and how long you hold your investment.
In a taxable brokerage account, mutual fund investors can generally encounter taxes associated with:
- Dividend or income distributions.
- Capital gains distributions made by the fund.
- Capital gains or losses when the investor sells fund shares.
Retirement accounts can have different tax rules. For example, investments held inside certain employer-sponsored retirement plans or IRAs generally do not create the same current-year taxable reporting as investments held in a regular taxable brokerage account.
Tax rules can be complicated and change over time. Consider your specific account type and tax situation when evaluating a mutual fund.
Risks of Investing in Mutual Funds
Mutual funds are investments, not guaranteed savings products. You can lose some or all of the money you invest.
Market risk
The value of stocks, bonds, or other securities held by a fund can decline.
Interest-rate risk
Bond funds can be affected by changes in interest rates. The effect varies depending on the securities and maturity characteristics of the fund.
Credit risk
Bond funds can be affected when issuers have difficulty making payments or their perceived credit quality changes.
Concentration risk
A fund that focuses heavily on a particular sector, country, industry, or asset type may be less diversified than its name alone suggests.
Manager or strategy risk
Actively managed funds depend on their investment process and management decisions. An active strategy may produce results that differ substantially from its benchmark.
Liquidity risk
Some underlying securities may be harder to sell during stressed market conditions, which can affect a fund's portfolio and ability to meet redemption activity.
Does Past Mutual Fund Performance Predict Future Returns?
No investment's past performance guarantees future results.
Historical performance can still provide useful information about how a fund behaved during different market periods, but it should be considered alongside the fund's objective, holdings, costs, risk, management approach, and other information.
A fund that performed strongly during one period can perform differently in another period.
How to Research a Mutual Fund
Before purchasing a mutual fund, review the fund's official information rather than relying only on its recent performance.
- Identify the fund's investment objective.
- Review the investment strategy.
- Examine the fund's holdings and diversification.
- Check the expense ratio and other fees.
- Understand whether the fund is actively managed or index-based.
- Review historical performance across different periods.
- Look at the fund's risk information.
- Review the prospectus and shareholder reports.
- Understand the applicable share class.
- Consider how the fund fits into your overall portfolio.
What Is a Mutual Fund Prospectus?
A mutual fund prospectus contains important information about the fund, including its objectives, strategies, risks, fees, performance, management, purchase and sale information, and tax information.
The SEC recommends reviewing a fund's prospectus before making an investment decision. A summary prospectus can provide a shorter version of key information, while the statutory prospectus contains more detailed information.
How to Buy a Mutual Fund
- Determine your investing objective. Consider what you are investing for, your expected time horizon, and the amount of risk you can accept.
- Choose the account. Mutual funds can be held through brokerage accounts and, where permitted, retirement accounts.
- Research available funds. Compare the objective, strategy, holdings, costs, risks, and share class.
- Read the fund information. Review the prospectus, fee information, and shareholder reports.
- Place the purchase. Mutual fund transactions are generally processed using the next calculated NAV.
- Monitor the investment. Review whether the fund continues to match your objectives and portfolio rather than focusing only on short-term price changes.
Mutual Fund Example
Suppose an investor places $5,000 into a hypothetical stock mutual fund.
The fund owns a diversified portfolio of companies. If the portfolio increases in market value, the fund's NAV can increase. If the underlying investments decline, the NAV can decrease.
The investor's actual result can also be affected by distributions, fund expenses, taxes, and the price at which shares are ultimately redeemed.
Target-Date Mutual Funds
Target-date funds are designed around a particular future year, often a retirement date.
These funds commonly invest in a combination of stocks, bonds, and other funds. Their asset allocation may gradually change as the target date approaches.
A target-date fund can therefore provide a packaged allocation strategy, but investors should still examine its asset allocation, fees, risks, and investment approach.
What Is a Fund of Funds?
A fund of funds invests primarily in other investment funds instead of directly purchasing individual securities.
This structure can provide exposure to multiple underlying funds, but investors should pay attention to the total fee structure because the investor may indirectly bear expenses of the underlying funds as well.
Common Mutual Fund Investing Mistakes
- Choosing a fund solely because it had strong recent performance.
- Ignoring expense ratios or other fees.
- Failing to understand the fund's investment objective.
- Assuming every mutual fund is broadly diversified.
- Ignoring the difference between active and index strategies.
- Overlooking the specific share class being purchased.
- Buying a fund without reading its prospectus.
- Forgetting that mutual fund distributions can create taxable events in taxable accounts.
- Treating a mutual fund as guaranteed or risk-free.
Mutual Fund Checklist for Beginners
- Know what the fund invests in.
- Understand the fund's objective.
- Know whether it is active or index-based.
- Review the expense ratio.
- Check for sales charges or other fees.
- Review the fund's holdings.
- Understand the fund's major risks.
- Review the prospectus.
- Consider the tax consequences for your account.
- Consider how the fund fits with your existing investments.
Frequently Asked Questions About Mutual Funds
What is a mutual fund?
A mutual fund pools money from multiple investors and uses the money to build a portfolio of securities such as stocks, bonds, or other investments.
How do mutual funds work?
Investors purchase shares in the fund. The fund invests the pooled money according to its stated strategy, and investors participate in the resulting gains, losses, income, and distributions.
What is NAV?
NAV means net asset value. It represents the value of the fund's assets minus liabilities divided by the number of outstanding shares. Mutual funds generally calculate NAV once each business day.
Do mutual funds pay dividends?
Mutual funds may distribute income generated by investments in their portfolios, including dividends from stocks and interest from bonds.
Can mutual funds lose money?
Yes. Mutual funds are investments and can lose value when the securities in their portfolios decline.
What is the difference between index and active mutual funds?
Index funds generally seek to track a specific market index, while actively managed funds use managers who select investments according to the fund's strategy.
How are mutual funds different from ETFs?
Both can provide diversified exposure to a portfolio of investments. Mutual fund shares are generally purchased or redeemed at the next calculated NAV, while ETF shares trade on exchanges throughout the trading day.
What is a mutual fund expense ratio?
An expense ratio represents a fund's ongoing operating expenses as a percentage of its assets. These costs reduce the return available to investors.
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Investment Disclaimer
The information on this page is for general educational purposes only and is not investment, tax, or financial advice. Mutual funds involve risk, and you can lose money. Investment objectives, strategies, fees, tax treatment, and risks vary by fund.
Before investing, review the fund's current prospectus, shareholder reports, fee information, and other official documents. Consider your own financial situation, goals, time horizon, and risk tolerance. Tax rules can change and may depend on your individual circumstances.