How Do Mutual Funds Work? The Complete Guide to Mutual Funds

how do mutual funds work

Are you a long-view investor with an interest in seeing your wealth grow over 10, 20, or 30 years? If the answer is yes, then you need a diverse portfolio of assets to help you achieve your goals.

One of these assets is a mutual fund. Mutual funds are a collection of assets grouped together according to an investment strategy and run by a fund manager. Compared to individual securities, mutual funds provide a certain level of protection against the volatility of the stock market and still deliver steady returns for investors.

How do mutual funds work? Keep reading for a quick primer.

What Are Mutual Funds?

Mutual funds are called investment baskets. Rather than being one form of security or investment on their own, mutual funds are a container for a group of different types of investments, usually stocks, bonds, or a combination of the two. However, they can contain other types of investments. The primary types of mutual funds include:

  • Equity funds
  • Bond funds
  • Balanced funds (equities and bonds)
  • Money market funds
  • Fixed-income funds

When you invest in a mutual fund, you invest in the basket of investments rather than a single stock or share. You also pool your money with all the other fund investors, which grants you access to investments that aren’t available to the average solo investor.

How Do Mutual Funds Work?

A mutual fund has a fund manager, who oversees the fund and chooses the investments found within it. The manager may choose to actively or passively manage the fund according to a set strategy or according to the manager’s whims.

Many mutual funds are increasingly passively managed because research shows that passive investments earn better returns compared to actively managed investments. It’s rare for active investment strategies to outperform the market.

How does the mutual fund make money? It depends on the type of fund you choose. When your investment earns you returns, it comes in the following forms:

  • Income earned via dividends
  • Growth in price of securities or capital gains
  • Fund share price (net asset value) grows

You’ll also pay fees for your mutual fund. These include the cost of the fund (e.g., administration and operating costs) and sales commissions. Keep in mind that these fees are typical percentages of the fund, and you’ll pay them annually. A fraction of a percent can be the equivalent of thousands of dollars.

The fees you pay depend on the structure of your fund. It pays to research the type of fund that best suits your financial goals and to compare fees between funds and fund providers.

Why Choose a Mutual Fund?

Mutual funds are increasingly popular because they offer even the novice investor something that the pros could only covet a few years ago: a diversified portfolio. Because you invest in a basket of investments, your profits and losses aren’t solely tied to one company’s performance. Diversity means you have a lower risk of losing everything if a stock performs badly.

Another reason investors of all types choose mutual funds is that they come with a fund manager. You don’t have to actively trade them or even worry about all the investments inside the basket. You pay the investor a fraction of a percent of the value of your account to worry about that for you.

By working this way, mutual funds use a high volume of transactions to reduce the cost for you as an individual investor. Rather than paying as much as $5 a transaction, you split the bill with other investors.

Are There Disadvantages of a Mutual Fund?

Mutual funds do come with disadvantages compared to other types of funds like exchange-traded funds (ETFs).

The biggest issue that investors find with mutual funds is that they can be expensive. Typically, mutual funds become very expensive with a small investment and then again at the top of the scale. Many providers offer the best rates to those with mid-size accounts.

Another issue with mutual funds is that they can be inefficient compared to ETFs. Efficiency applies both to tax efficiency and the cost of maintaining the fund vs. the returns it offers. ETFs generate fewer capital gains distributions, and they have their own way of buying and selling that triggers less taxable income. However, you may find that some passively managed mutual funds are also tax efficient if only because they generate fewer transactions.

How to Find the Right Mutual Fund

Although there’s a shortlist of widely popular mutual funds, a fund’s popularity doesn’t necessarily mean it’s right for you.

Finding the right mutual fund requires you to find a fund that meets both your financial goals and your risk tolerance as well as a philosophy that reflects your own investment philosophy.

From there, you can start to consider the costs of the fund and the management style to whittle down your list of contenders and begin investing.

Use our guide to choosing the best performing mutual funds to get started.

Are Mutual Funds Right for You?

How do mutual funds work? They pool investors’ money together in a basket of securities to provide long-term growth with some protection from market volatility.

Mutual funds are a diverse group of investment tools, but almost every investor can see some benefit in adding top-performing funds to their portfolios. The trick is to find the fund that best matches your personal goals and your investment philosophy and strategy.

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