What Are Mutual Funds and How Do They Work?

Different mutual funds have different objectives, and different types exist to suit different investment strategies. 

Milly Vueti via Unsplash; Canva

What Is a Mutual Fund?

A mutual fund is essentially a professionally managed portfolio of stocks and/or other securities funded with a pool of capital sourced from many individual investors. 

Each investor receives interest payments and dividends proportional to the amount of capital they have invested in the fund.

Mutual funds are popular because they allow investors to buy into a carefully curated and well-diversified basket of securities put together by a professional investor or team of investors with a particular goal or objective in mind. Every mutual fund has a prospectus, which is a sort of mission statement that outlines the fund’s specific investment aims and objectives, associated fees, and other important information.

Common Types of Mutual Funds

Many different types of mutual funds exist to suit the goals of different types of investors. Equity funds and mixed funds that contain equities are by far the most common, but bond funds are also popular.

Equity Funds

Equity funds are mutual funds that invest in stocks. Because stocks are volatile, equity funds have higher risk and higher return potential than bond funds or mixed funds. There are many types of equity funds:

  • Small, mid, and large-cap funds: Some mutual funds exist to track portions of the stock market based on company size as measured by market capitalization. Small-cap funds invest in companies with market caps between $300 million and $2 billion, mid-cap funds invest in those with caps between $2 and $10 billion, and large-cap funds invest in those with caps of $10 billion or more.
  • Industry funds: Some funds focus on a particular industry like mining, cloud computing, or healthcare.
  • Index funds: Some funds invest in the composite companies of particular stock indexes like the S&P 500 to attempt to mirror their returns.
  • Growth funds: Some funds attempt to invest in companies with large growth potential (like up-and-coming tech companies) in an attempt to achieve higher returns than the market.
  • Value funds: Some funds invest in stocks that managers believe are undervalued (trading below their intrinsic value) by the market with the hope that they will go up significantly in price.
  • Dividend funds: Some funds invest in companies that pay regular dividends with the goal of providing fixed income payments for investors.

Bond Funds

Some mutual funds invest exclusively in government and/or corporate bonds. Bond funds don’t have much return potential compared to equity funds, so they are popular among investors seeking low volatility and regular income payments. Many investors use bond funds as an alternative to high-yield savings accounts.

Allocation Funds

Allocation funds invest in equity and debt at fixed proportions (e.g., 65% stocks, 35% bonds) and are popular among investors with moderate risk tolerance who value stability, fixed income payments, and moderate growth potential.

Other Types of Mutual Funds

Many additional varieties of mutual funds exist with focuses that range from real estate to commodities to futures to environmental or social responsibility. Mutual funds exist for almost every imaginable investment strategy and asset class.

What Are the Costs Associated With Investing in a Mutual Fund?

Every mutual fund is different, but most charge one or more fees. It’s important for investors to compare the fee structures of any mutual funds they are interested in buying into, as these fees can significantly impact returns.

Expense Ratios

In exchange for their professional management and their ongoing administration (i.e., office costs, staff salaries, etc.), mutual funds charge investors a certain percentage of their total amount invested annually. This percentage fee is known as an expense ratio. Expense ratios vary from around 0.01% to around 2.5% depending on the nature of the fund, but ratios between 0.5% and 0.75% are most common.

Sales Loads

Loads are commissions paid to brokers when investors buy or sell mutual fund shares. Front-end loads are paid at the time of purchase, whereas back-end loads are paid at the time of sale. Funds that do not charge sales loads (of which there are many) are called no-load funds.

Account Fees

Some funds charge fees for account maintenance, particularly if an investor’s balance falls below a minimum amount. Not all mutual funds charge these sorts of fees.

Redemption Fees

Some funds charge investors a fee if they sell their mutual fund shares within a relatively short period after purchasing them. This span can vary depending on the fund, and not all funds charge these sorts of fees.

Note: Some mutual funds offer different share classes (usually A, B, and C). Different share classes incur different fees at different times, so it’s important for investors to choose the appropriate class for their needs.

Advantages and Disadvantages of Mutual Funds

Mutual funds offer investors an easy way to maintain a diversified and professionally managed portfolio based on their goals and needs, but this convenience comes with fees, tax implications, and other potential downsides. 

Pros Cons

Strategic but hands-off

Expense ratios and other fees

Professional management

Lack of control over taxable events

Instant diversification

Once-daily trading

Lack of voting rights

Mutual Funds vs. ETFs: What Are the Differences?

Mutual funds and ETFs (exchange-traded funds) are similar in that they are both pooled-capital investment vehicles that allow investors exposure to many different securities via only one investment. Additionally, both ETFs and mutual funds can track indexes, industries, or companies of a particular size.

However, mutual funds differ from ETFs in several important ways. First, ETFs are usually more passively managed, whereas most mutual funds are more actively managed, meaning the fund manager can add or remove stocks at will based on ongoing market analysis.

Additionally, mutual funds may have different classes of shares with varying fees, whereas ETFs do not. Since ETFs trade on exchanges like stocks, they can be bought and sold throughout the day, whereas mutual fund trades only close once per day at the end of trading hours.

Because ETFs are usually passively managed, they don’t have sales load fees, or other costs associated with mutual funds. That being said, most do have expense ratios, but these are often lower than the ratios of comparable mutual funds. Most ETFs can be traded without commission via brokerages like Schwabb, Robinhood, or Fidelity.

What Is a Mutual Fund’s Net Asset Value (NAV)?

At the end of every trading day, a mutual fund’s net asset value is calculated. This value is calculated by subtracting the fund’s liabilities from its assets (cash and securities) then dividing this result by the number of shares outstanding. In other words, a mutual fund’s NAV is the value of its holdings as of the end of each trading day less its expenses on a per-share basis.

How Are Mutual Fund Investors Taxed?

Mutual fund shareholders are taxed based on any taxable events that occur as a result of the fund manager’s decisions. In other words, if a stock within the fund is held and sold in less than a year, shareholders are taxed at their regular income rate on their proportional gains. If a stock within the fund is held for over a year, shareholders are taxed at the long-term capital gains rate. Essentially, shareholders are taxed as they would be if they were placing the manager’s trades themselves.

Where Are Mutual Funds Bought and Sold?

Unlike stocks and ETFs, mutual fund shares don’t trade on exchanges like the NYSE. They can only be bought and sold through their managing companies or via third-party brokerages.