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Updated on Wednesday, January 9, 2019
Nearly half of all American households own at least one mutual fund, according to 2017 estimates by Investment Company Institute, and mutual funds represent 67% of 401(k) plan assets. If you participate in an employer-sponsored retirement plan, you may be investing in mutual funds with each paycheck. But for something so ubiquitous, they are not well understood. Learn more about exactly how mutual funds work before you make your next investment.
What is a mutual fund?
A mutual fund is a pool allowing many investors to own portions of a larger investment portfolio of stocks, bonds and other types of securities. Most are known as open-end investment companies or open-end funds because investors are continuously buying or selling shares. (The two other types of investment companies — closed-end funds and unit investment trusts — only sell a limited or specified amount of shares, similar to an initial public offering.) Mutual fund shares are redeemable, meaning you can sell at any time and the fund buys them back from you.
The Securities and Exchange Commission regulates mutual funds and the managers selecting fund investments. All mutual funds start with a stated objective and investment strategy (included in the fund’s prospectus), a detailed offering document you can get through the fund company, broker or SEC.gov.
By investing in mutual funds, you’re easily exposed to a variety of markets, sectors and investment asset classes, but some funds can be riskier than others.
How to buy mutual funds
You can buy shares of mutual funds directly from the fund company, through a broker or through your employer-sponsored retirement account.
A mutual fund share is a portion of ownership in the fund and a percentage of its growth. What you pay for each share is called the net asset value (NAV), or the fund’s value per share minus its liabilities. The NAV is calculated once per day at the close of the market after investors have purchased shares, so you may not know the exact NAV you paid until after purchase.
The cost you pay to be a mutual fund investor is known as its expense ratio, which is charged on an ongoing basis as a percentage of invested assets. Some funds may also charge added fees when you purchase shares (“front-end loads”) or when you sell them (“back-end loads”). There may also be distribution fees, minimum balance fees, short-term trading fees and so on.
Fees and expenses decrease your investment return, so it’s important to understand what you will be charged for before you invest. If high fees are a concern, there are plenty of “no-load” and low expense ratio fund options to choose from.
Types of mutual funds
Stock mutual funds invest in a variety of stocks or equities, representing ownership shares in corporations. Stock funds may invest according to a growth or value strategy, or within a particular sector or region. Stocks have consistently produced the highest rate of return over time, but because values can rise and fall quickly, they can be riskier than other asset classes.
Bond mutual funds hold fixed-income investments representing government, municipal or corporate debt. Bonds may be considered less risky, but different investing strategies carry various types and levels of risk.
Money market funds invest in high quality, short-term government or corporate bonds that are considered low risk. The goal of the investment is stability, so money market funds offer minimal returns.
Hybrid funds or balanced funds invest in some combination of stocks, bonds and money market securities to balance the risk of the overall fund with potential growth.
Actively managed vs. passively managed funds
The majority of mutual funds have a professional manager or management team selecting investments with a goal to outperform a given benchmark. These managers are paid by the fund, which can impact the expense ratio and dampen the fund’s performance. This is one reason the majority of active mutual fund managers underperform their index benchmarks.
Passively managed funds like index funds aim to match the benchmark rather than beat it. These funds track market indices such as the Standard & Poor’s 500 or Russell 3000. Because a computer model effectively runs them, index funds have lower overhead and are generally lower cost.
Similarly, exchange-traded funds (ETFs) are a lot like mutual funds concerning SEO regulation and investment options — most are indexed, some are actively managed. The key differences are in how you buy them. Shares of ETFs trade on an exchange, and are bought and sold throughout the day just like stocks. Investors pay market value, which may be different from the NAV calculated at the end of the day. You will also pay a brokerage fee to trade ETF shares.
How you earn money with mutual funds
Investors can earn money from mutual funds in three basic ways:
- Income distributions. When the underlying investments pay dividends or interest, mutual fund investors participate in these gains. Mutual funds pay annual distributions, which can be reinvested into the fund if you choose.
- Capital gains distributions. Investments are bought and sold often within mutual funds. If sold at a gain, investors realize a capital gain that’s paid as an annual distribution or reinvested into the fund.
- NAV increases. As the underlying investments gain value, the mutual fund’s share value increases. If you sell shares of your mutual fund for more than you paid for them, you realize a capital gain.
If investors hold mutual funds within tax-favored accounts like an IRA or 401k, they do not have to report gains or losses on an annual tax return until they sell the fund. Invest through a taxable account, and you will need to report mutual fund dividends with yearly income taxes, along with short-term (for investments held less than one year) and long-term capital gains or losses, depending on your tax bracket.
How mutual funds work: Reasons to invest
- Ease of use. The average investor can own nearly anything through a mutual fund, through shares that can be redeemed at any time and at a fair price.
- Affordability. Many funds require investment minimums of at least $2,500, but some will waive them if you agree to regular monthly contributions. In 2018, Fidelity began offering index funds with no minimum balance.
- Diversification. It’s an essential investing concept: Spread your risk by owning a broad base of investments instead of just one. With a single mutual fund purchase, you can gain exposure to a diversified asset class or even a balanced portfolio to suit your goals and risk tolerance.
- Professional management. If you like the idea of someone selecting and monitoring investments for you, mutual funds offer direct access to professional asset management. With this perk comes a loss of control, and as an investor, you may not have much transparency into fund holdings. Investigate the long-term track record of the fund manager, including years of experience, performance and any deviations from strategy.
Know exactly what you’re buying and mutual funds can be a great investment to help you reach long-term goals. Look for funds that are consistent long-term performers, rather than the year’s hottest picks. And pay attention to fees; all else being equal, a fund with high fees must outperform one with low fees to produce the same return. Favoring low-cost funds is a sure way to boost your profit.