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What Are Mutual Funds?

What Are Mutual Funds?
Chris Muller
Updated August 30, 2021
11 Min Read

Are you looking to start investing? Mutual funds are a practical option to consider. 

Mutual funds are financial vehicles that pool your money with other investors’ funds, so basically, you are investing in securities together with many others collectively. Investing in mutual funds is more affordable than buying stocks or shares outright, making these investments accessible for beginner investors or those with only a few hundred dollars to spare. 

Read on as we explain everything you need to know about investing in mutual funds. 

What Is a Mutual Fund?

A mutual fund is an investment that pools money from many investors and uses the collective funds to invest in stocks, bonds, or other securities. When you invest in a mutual fund, you do not actually own a share of a company. Instead, you share the profits or losses from your collective investment equally with the other investors.

Mutual funds allow small investors to participate in highly profitable securities without forking over thousands of dollars. Many mutual funds have an individual purchase minimum ranging from $500 to $3,000, but some brokers offer lower minimums or waive them altogether.

Investing in mutual funds is an easy, effective way to diversify your investment portfolio without needing to purchase your own stocks or securities. Additionally, because a money manager makes all of the investment decisions for the fund, you do not need to have any special knowledge about investing to take advantage of these financial vehicles. 

However, unlike purchasing your own stocks, investing in mutual funds takes away your control over the securities in the portfolio. Your portfolio, and the decisions involved in its investments, are at the mercy of your mutual fund manager. 

If you pay into a 401(k) through your employer, you may already be investing in mutual funds. Most 401(k) plans consist of several long-term mutual funds, which is why you typically have to pay fees to withdraw your earnings early. 

How Mutual Funds Work

Mutual funds utilize all of the money in an investment pool to purchase many different securities, such as stocks or bonds. 

Investing in mutual funds works differently than investing in stocks or bonds. Instead of purchasing a portion of ownership of a company, when you invest in a mutual fund, you are buying a small part of the value of the entire portfolio. 

A mutual fund portfolio consists of many securities, and purchasing a mutual fund allows you to invest in all of the securities at once. 

Professional money managers execute all of the actions involved in the mutual fund portfolio. These managers are in charge of allocating the assets within the fund pool to various securities, and they watch the market closely to make profitable decisions for the portfolio.  

Because mutual funds consist of dozens or even hundreds of different securities, the portfolio’s performance is not dependent on the performance of one specific company or sector. If one company in a portfolio has a bad quarter, the portfolio’s overall value will only decrease slightly because the other securities offset it.  

Mutual funds are often part of a larger investment company, such as Fidelity Investments or Oppenheimer. These companies offer a wide range of mutual funds to their investors.

How Mutual Funds Make You Money

The shareholders in a mutual fund have proportionate rights to the gains or losses of the portfolio. Mutual fund investors can earn money from these portfolios in three ways:

  1. Dividends: Mutual funds earn dividends that fund managers pay out to all of their investors as distributions each year. These distribution payments depend on the income accrued by all of the fund’s securities. 
  2. Capital gain: You may already know that investors make money by buying shares at a low price and selling them when they increase in value. Money managers do the same with the securities in a mutual fund portfolio. When managers make profitable sales or trades, they will divide the capital gains among investors. 
  3. Selling shares: You can also make money on mutual funds by selling your fund shares after they increase in value.

Most mutual fund companies pay out these earnings in the form of a check or as a credit toward additional shares. 

Types of Mutual Funds

Investors classify mutual funds into several different categories based on the securities within their portfolios. Many of these categories relate to the securities’ sectors, locations, sizes, or other various factors. 

Let’s discuss the two primary mutual fund distinctions—active or passive—then summarize the most prevalent types of mutual funds in the market. 

Active vs. Passive Mutual Funds

Fund managers make decisions about their portfolios either actively or passively. 

Actively managed funds are ones that cycle through securities frequently to maximize profits and performance. Managers of active mutual funds buy and sell fund securities daily, making these portfolios riskier overall. 

Active fund managers try to outperform the market by making heavily researched decisions about how to invest the fund’s pool of money. Because these managers are skilled, professional investors, you should expect to pay higher fees to purchase shares in these funds. 

Alternatively, passive funds attempt to match the performance of the market rather than outperform it. While a manager still oversees passive mutual funds, he or she will not buy and sell the fund’s shares as frequently as an active manager and does not need to have as much professional investing experience. 

Active funds are often more profitable than passive ones even though their value may fluctuate daily. However, passive funds come with lower fees, making them the favored choice for beginner or casual investors. 

Balanced Funds

Balanced funds are mutual funds that invest in a relatively fixed mix of stocks, bonds, and money market funds, reducing the risk that comes with sticking to one security type. Investors participate in mutual funds with the goal of producing income and capital gains that outpace inflation. 

Balanced funds are a reasonable choice if you are a casual investor or are looking to supplement your current financial needs.

Bond Funds

Bond funds, also known as debt funds, invest in bonds and other debt instruments. These funds often have active management, and their money managers seek to invest in undervalued bonds and sell them for profit. 

Bond funds tend to be more profitable than money market investments, but they also come with interest rate risk and a high chance of variability. 

You may want to consider investing in bond funds if you are looking to generate monthly income. 

Equity Funds

Equity funds are mutual funds that invest primarily in stocks. These funds can be either active or passive and consist of various subcategories relating to size, investment approach, or location. 

A few of the most prevalent equity fund categories include:

  • Small-cap: Small-cap equity funds invest in stocks with a market cap between $300 million and $2 billion. These stocks tend to be from small, new companies, making them riskier to invest in. 
  • Mid-cap: Mid-cap equity funds invest in stocks with a market cap between $2 billion and $10 billion. 
  • Large-cap: Large-cap equity funds invest in stocks with a market cap of over $10 billion. 
  • Value: Value equity funds consist of stocks in primarily high-quality, low-growth companies, such as those with low price-to-earnings (P/E) ratios or price-to-book (P/B) ratios.  
  • Growth: Growth funds look to invest in companies that have had or may have a solid increase in earnings and sales, giving them high P/E ratios. 
  • Blend: Blend equity funds are in the middle of growth and value funds, with moderate P/E ratios.

Mutual funds often combine several of the above strategies to produce capital gains.

Income Funds

Income funds are mutual funds that have the primary goal of providing steady cash flow for their investors. Money managers of income funds often invest in government debt or other securities that offer ongoing interest or dividends, leading to fast and frequent payouts. 

Trusts and partnerships tend to organize income funds rather than corporations to ensure that income fund investors stay on top of taxes. If you are a conservative investor looking to make steady income through mutual funds, you may want to look into income funds. 

Index Funds

Index funds are mutual funds that focus on staying consistent with the market rather than beating it. Index fund managers look at market indices such as the Dow Jones Industrial Average (DJIA) or S&P 500 then buy stocks that perform highly on these indices. 

While fund managers can actively manage index funds, they do not have to perform as much research to identify stocks to add to these portfolios. As a result, index funds are relatively affordable compared to other mutual funds.

Money Market Funds

Money market funds are low-risk, low-reward mutual funds. These fund portfolios typically consist of short-term debt-based securities, such as treasury bills, making them a safe place to invest your money for short periods. 

Investors who participate in money market funds typically see returns that are somewhere between the interest you would earn on a savings account and what you would earn on the average CD. While these returns are relatively low, your chance of losing money in a money market fund is also low. 

Specialty Funds

Specialty funds are a kind of catch-all category of mutual funds. These portfolios consist of securities from the same industry or region, focusing on a specific specialty rather than security type.  

Sector funds are a popular variety of specialty funds that consist of securities in one sector, such as the financial, health, or technology sector. Regional funds are specialty funds that focus on a geographic region, such as an individual country or a group of countries (e.g., Latin America). 

The risk of investing in specialty funds correlates to the volatility of the sector or region. If a region enters a recession, your regional fund will drop in value. If stocks in a sector drop, your portfolio value will also decrease. 

You may choose to invest in a specialty fund if you want to support a specific industry or region. 

Mutual Fund Fees

To invest in a mutual fund, you will need to pay annual fees known as expense ratios. These annual operating fees are typically between 1% and 3% of the portfolio’s value and include the administrative costs of operating the mutual fund. 

Mutual funds may also charge shareholder fees or commissions when investors buy or sell their mutual funds. These sales charges, known as loads, may occur when investors purchase the shares (front-end loads) or upon selling their shares (back-end loads). 

Some investment companies offer no-load mutual funds, meaning that investors do not have to pay any commission upon purchasing or selling their funds. Other companies charge additional fees for withdrawing or selling funds early. 

Classes of Mutual Fund Shares

Mutual funds offer shares in several different classes. The most significant difference between each class relates to the amount of the fees you will need to pay to participate in the share. However, because each class charges fees at different times and in different amounts, it may be challenging to determine which class will be most profitable for you. 

Here is an overview of the four primary mutual fund share classes to help you discern the right class for your investment strategy. 

Class A Shares

The first share class is Class A. Class A shares charge front-end fees of 5% or more. Your money manager will subtract these fees from your initial investment. 

A-shares also charge 12b-1 fees, which are the management fees included in the fund’s expense ratio. While Class A 12b-1 fees are lower than other share classes, they will still increase your overall charges. 

If you are looking to purchase mutual funds with A-shares, you will probably need to go through a broker. 

Class B Shares

Class B shares are mutual fund shares that have back-end fees. When you invest in a B-share, you will not need to pay any fees until you sell your shares after a specific period. As a result, your entire initial investment will earn interest and capital gains without having to subtract any fees from your investment amount. 

B-shares are ideal for investors who do not have much cash to invest initially in mutual funds. Waiting until your portfolio becomes highly profitable before selling will ensure that you can afford your back-end fees and still walk away with capital.  

B-shares are also best for investors who have a long time horizon. The longer you hold your B-shares, the lower your deferred fees will be. 

While B-shares still exist across the market, they have begun dying out in favor of A and C shares that place a more regulated focus on fees. 

Class C Shares

Class C shares are mutual fund shares that charge level-load fees. These funds do not include any front-end fees, and their back-end loads are often 1% or less. Many C-shares remove the back-end fee after investors hold onto the shares for a year. 

One downside of C shares is that their expense ratios tend to be higher than A-shares. Their management fees do not decrease over time as with A-shares, so C-shares are suitable for investors with short time horizons.

Clean Shares

Clean shares are a relatively new class of mutual fund shares. These shares do not have any front-end or 12b-1 fees, saving investors money and giving them more clarity about their overall expense ratios. 

Advantages of Mutual Funds

Mutual funds offer several advantages to shareholders over other financial securities:

  1. Simplicity: Individuals with no investing experience or knowledge can invest in mutual funds and leave all of the decision-making up to their money manager. Mutual funds are also relatively easy to purchase and sell through major stock exchanges, making them some of the most straightforward securities. 
  2. Diversification: Mutual funds consist of dozens or hundreds of different securities. Investors who participate in mutual funds instantly diversify their portfolios without having to pick and choose the securities individually. Investing in several mutual funds will diversify your portfolio further with minimal effort on your part. 
  3. Accessibility: Mutual funds are accessible to every investor. You can purchase these funds through a traditional broker, online broker, bank, insurance company, or a designated mutual fund company. Beginners can open investment accounts with online brokers in a few minutes and immediately begin participating in mutual funds. 
  4. Affordability: Mutual funds tend to be relatively affordable, with minimum investment amounts ranging from $500 to $3,000. Some mutual funds, such as those in 401(k) plans, have no minimums. As a result, new or young investors can begin profiting off these securities with little initial investment. 
  5. Variety: The mutual fund types we discussed earlier only begin to touch the dozens of varieties available. Even though investors cannot choose each security in a fund, the wide range of mutual fund options gives investors significant freedom in their investment decisions. 

While every financial vehicle has its downsides, mutual funds are suitable investment opportunities for many investors. 

How to Buy a Mutual Fund

To purchase a mutual fund, you will need to have an account with a bank, brokerage firm, or insurance company that offers mutual funds. You can also invest through a specified mutual fund company. If you do not have an account with any of these organizations, you can typically create one in a few minutes online. 

The company through which you choose to invest plays a role in the fees you will pay as part of your investment. Most mutual fund companies charge management fees that will decrease your initial investment amount. 

Once you choose an organization through which to invest, you will need to place an order for the mutual fund in which you would like to participate. You can typically place orders over the phone, online, or in person, depending on the organization with which you are working. 

Your order will include the following information: 

  • The amount of money you would like to invest
  • The exact mutual fund in which you would like to invest

Your mutual fund share price depends on the closing share price from the end of the current day. You can view this information on financial websites such as Yahoo Finance or on the investment company’s website itself. 

Once you place your order, your investment company will purchase your shares in your name. You can keep or sell them as you see fit, but keep in mind that some mutual funds charge additional fees for selling or withdrawing too early. 

Minimum Required Investment and Net Asset Value (NAV)

Most mutual funds have a minimum required investment amount that the fund manager determines. As you search for a mutual fund to purchase, be sure to keep an eye on each fund’s minimum amount. If a fund catches your eye that is outside your budget, we recommend waiting until its minimum decreases rather than settling for a more affordable, less profitable option. 

A mutual fund’s net asset value (NAV) is the price that investors will pay to purchase a share of the fund. Unlike stocks and other securities that fluctuate in price throughout the day, the stock market adjusts a fund’s NAV once at the end of each day. 

If you place your mutual fund order before the end of the day, you should keep in mind that its NAV may fluctuate by the time the order goes through. We recommend investing a fixed dollar amount to ensure that the price you pay for a fund does not change after placing your order. 

Robo-advisors

If you’d prefer to stay out of the investment process entirely, you can call upon a robo-advisor to invest in mutual funds for you. Robo-advisors are algorithmic programs that automatically invest your money into mutual funds.

Robo-advisors are a practical solution for investors who do not want to spend much time or energy choosing the best mutual funds. They are also ideal for investors who do not want to spend money hiring a professional to select their securities for them. 

However, robo-advisors remove any personal freedom from your investment strategy. When you pay for a robo-advisor, you entrust it to make the right decisions for you while understanding that your profits or losses are outside your control.

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