What Is a Mutual Fund? - MagnifyMoney

What Is a Mutual Fund?

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If investing were a dessert menu, mutual funds would be the pie. There’s a flavor for everyone, and no matter how small of a slice you take, you still get the full experience.

As we dive into answering “What is a mutual fund?” we’ll review everything you need to know about these so-called investment pies — including what makes up the “filling” and how they work for your investment portfolio.

What are mutual funds?

Mutual funds are baskets of investments that investors can buy for a fraction of the cost it would take to own all the investments in the basket individually. For example, you can buy a share of the Fidelity 500 Index Fund (FXAIX), a fund that holds 506 individual stocks, for $1. It would take thousands of dollars to buy each of those stocks individually. Tesla (TSLA) alone trades at close to $900 per share, and that’s only one of the 506 stocks inside this Fidelity index fund.

And that’s the beauty of mutual funds: Like a pie, each slice has the same filling — which can be stocks, bonds or almost any other investment — in the same ratio as the rest of the pie. So your $1 of FXAIX has the same proportion of all 506 stocks as the whole fund, which makes mutual funds great foundations for diversified portfolios.

How do mutual funds work?

Mutual funds combine money from multiple investors into a single pool (the pie) and use those funds to buy various investments (the filling).

A fund manager is in charge of using investors’ funds to purchase investments that align with the fund’s strategy. These can range from stocks, bonds and commodities to alternative investments like real estate investment trusts (REITs) or even precious metals like gold. If there’s an asset worth investing in, there’s likely a fund for that asset.

Most funds are open-ended, meaning the fund can continuously issue new shares; there’s no cap on the number of shares issued. By contrast, closed-end funds work by offering only a fixed number of shares, which then trade like shares of stock.

Open-end funds are unique in that trades are filled directly by the fund manager rather than between individual investors. At the end of each trading day, the fund manager will calculate how much the fund’s portfolio is worth, called its net asset value (NAV), and then fill any open buy and sell orders at that price.

How do you make money with mutual funds?

There are three ways you can make money with mutual funds:

  • Capital appreciation. As the value of the assets in the fund increases, your investment value increases.
  • Income distributions. When the investments inside a fund pay dividends or interest, the fund manager passes these on to shareholders as income distributions.
  • Capital gains distributions. If the fund manager sells an investment inside the mutual fund at a gain, those gains get passed onto investors through an annual distribution.

One of the best ways to make money while investing in mutual funds is through a dividend reinvestment program (DRIP).

DRIP programs automatically reinvest your income and capital gains distributions back into the fund by using the money you receive to buy more shares. Then, when the next distribution comes around, you’ll have more shares to generate more distributions, which you can then reinvest to generate more future distributions. It’s a compound interest for mutual funds.

What are the benefits of mutual funds?

Where do we begin? Mutual funds have a plethora of benefits that make them such potent investment vehicles, such as:

  • Variety. There’s a fund for every investor profile, whether you’re looking for stocks, bonds, alternative investments, real estate or complex investing strategies.
  • Liquidity. Since you trade mutual fund shares directly with the fund manager, you’re guaranteed there will always be someone willing to buy when you’re ready to sell.
  • Low cost. Fund providers are increasingly lowering their minimum investments and fees, with some funds having $0 minimums and zero fees.
  • Accessibility. Many funds have no investment minimums, making them accessible to a wide range of investors.
  • Transparency. Mutual funds must disclose their holdings and fees so you always know what you’re buying and how much it costs to be an investor.
  • Diversification. You can gain exposure to hundreds or even thousands of individual investments with a single fund, creating instant diversification.
  • Professional management. Professional managers keep a fund’s investment strategy on track and balanced.

Are there different types of mutual funds?

There are more than 131,000 open-ended funds worldwide, so when we said there’s a mutual fund for every investor’s taste preference, we weren’t kidding.

Mutual fund asset classes and strategies

Mutual funds invest in a range of asset classes. Some focus on only one asset class, like stocks or bonds, while others combine multiple classes to achieve different investment strategies.

But only one thing determines the assets held in a fund: the fund’s investment strategy. For example, a fund with a capital appreciation goal may prioritize growth-centric assets like growth stocks. On the other hand, an income-centric fund may use bonds and dividend-paying stocks to deliver investors a consistent income stream.

Asset class-specific funds

  • Stock funds primarily invest in stocks, making them good choices for investors looking for long-term growth.
  • Fixed-income funds primarily invest in bonds or other fixed-income instruments like certificates of deposit (CDs).
  • Balanced funds, also called asset allocation funds, invest in a mix of stocks and bonds.
  • Money market funds invest in the shortest-term U.S. government or corporate bonds to deliver slightly higher returns than a savings account.
  • Bond funds invest in certain bond types, generally to track a particular income or tax strategy.

Stock funds by company size

  • Large-cap funds. These funds invest in the largest companies by market capitalization. Large-cap stocks generally have a market value of $10 billion or more.
  • Small-cap funds. These funds invest in small companies with $2 billion or less in market capitalization. Small cap stocks are typically more volatile than large-cap stocks because there’s a higher probability of a small company not succeeding.
  • Mid-cap funds. Mid-cap funds invest in companies with market capitalizations of $2 billion to $10 billion. Mid-caps tend to provide more growth potential than large caps but less volatility than small caps.

Stock funds by region

  • Domestic funds invest predominantly in U.S.-based companies.
  • International funds invest predominantly in foreign-based companies.
  • Global funds invest in both domestic and foreign companies.
  • Developed market funds invest in countries with established economies, such as the U.S. and Europe.
  • Emerging market funds invest in countries and regions undergoing economic transition and are categorized as emerging markets by the MSCI Emerging Market index.

A fund could also be categorized by its investing strategy or goal, such as a growth, balanced or income fund. But to better understand any fund’s investment strategy, you can review its “investment objective” in the fund’s prospectus.

Actively managed vs. passively managed mutual funds

Mutual funds can also come in two different management styles: actively and passively managed.

  • Actively managed funds have a portfolio manager who makes ongoing buy and sell decisions based on their beliefs about the market’s future.
  • Passively managed funds (or index funds) have a portfolio manager who follows the lead of an index or other benchmark, only buying and selling to make the fund mirror the benchmark.

Actively managed funds tend to have lower expense ratios than passively managed funds since the fund manager isn’t buying and selling at a high volume throughout the year.

Do mutual funds have fees?

Fees are dropping across the investing industry, with mutual funds leading the way. It’s possible to find no-fee funds, such as Fidelity’s Zero index funds, which launched in 2018. As a mutual fund investor, however, it helps to know the fees you’ll encounter with any mutual fund.

Expense ratio

A mutual fund’s expense ratio represents the fund’s annual operating costs, like manager compensation and overhead.

Sales load

A sales load is a fee you pay when you buy or sell shares of a fund. Whenever possible, look for no-load mutual funds which don’t charge sales fees.

Transaction fee

Some mutual funds carry transaction fees. These include sales charges, or loads, which you might pay when you purchase or sell a mutual fund, or early redemption fees, which you’d pay if you sell a fund within a specified early redemption period.

How are mutual funds rated?

Mutual funds are usually rated based on past performance, typically by Morningstar, the most well-known fund rating firm.

Morningstar evaluates a fund and assigns a rating between 1 (lowest) and 5 (highest) stars to rate the fund’s performance against its peers:

  • 5-star funds rank in the top 10% of their peer group.
  • 4-star funds rank in the next 22.5% of their peer group.
  • 3-star funds are average, ranking in the next 35% of their peer group.
  • 2-star funds are below average, ranking in the bottom 22.5% of their peer group.
  • 1-star funds are in the bottom 10% of their peer group.

Funds must have a track record of more than three years to receive a Morningstar rating.

How to invest in mutual funds

You can buy shares of mutual funds directly from the fund company, through an online broker or through your employer-sponsored retirement account. Depending on the type of account you’re using to invest, you could be subject to investment minimums. Some funds have no minimum, while others can have minimums of $1,000 or more. However, investment minimums for retirement accounts are often lower.

Why invest in mutual funds?

There’s a reason pies have been a part of the human diet for centuries: They’re an excellent vessel for just about any ingredient combination you can imagine. The same is true of mutual funds. Once you know what flavor of investment you want, finding the best mutual fund that offers that mix is simple.

So no matter where you are on your wealth-building journey, mutual funds can provide an easy and affordable way to create a diversified portfolio.

Frequently asked questions

Unfortunately, the IRS doesn’t allow investors to deduct mutual fund management fees on their taxes.

Mutual funds can be a good investment if you do your research and choose wisely. However, as mutual funds can vary by asset class and investment strategy, it’s essential to do your research before investing.

Some mutual funds pay dividends. To identify funds with a consistent dividend output, you can search for funds with “income” or “dividend yield” in the name. Regardless of fund type, funds are legally required to pay dividends annually. However, income-centric funds may pay out dividends as often as monthly.