A mutual fund is an investment vehicle that aggregates money from many individuals and invests it in stocks, bonds, and other securities.
Learn how a mutual fund functions, the various types of funds, and their pros and cons to determine whether this type of investment suits your financial objectives.
What Is a Mutual Fund?
A mutual fund takes money from a group of people and invests it in a basket of stocks, bonds, and other securities. This basket is known as a portfolio and represents a range of companies and sectors.
How a Mutual Fund Works
Mutual funds can be traced all the way back to 1774 when Dutch merchant Adriaan van Ketwich proposed a financial arrangement that involved pooling money from multiple investors to make investing available to the masses rather than a rich man's game alone. Others date its origins to 1822 when King William I of the Netherlands was thought to have created the first closed-end investment company. However, the first modern mutual fund wasn't introduced until 1924.
Today, mutual funds are among the most popular ways for beginner or passive investors to grow their money, because they're easy to understand. In the simplest terms, a mutual fund is akin to a basket of investments holding stocks, bonds, short-term debt, or a blend thereof that is typically chosen and managed by one or more investment professionals.
Each mutual fund has a unique objective that the fund manager attempts to meet by following a specific management strategy. It might invest in stocks from around the globe, a particular region or country, or stocks of companies that pay high dividends or have quickly growing revenues. Its managers might also select stocks they believe are undervalued or bonds they believe are less prone to credit risk.
No matter the goal of the fund, buying shares in a mutual fund is similar to buying shares in a publicly-traded company in that every share you buy of a mutual fund represents your partial ownership in the fund and the money it makes. The key distinction is that with a mutual fund, you buy shares of a portfolio of company stock or other securities rather than the stock of a single company.
A mutual fund is an open-end investment—that is, one that can issue and redeem shares whenever it wants. After you buy shares in a mutual fund, you can sell them back to the fund—either directly or through a broker—for roughly the shares' net asset value (NAV).
The fund's NAV is simply the value of the fund's assets minus its liabilities and is calculated once every trading day, generally after the close of exchanges. The NAV of a single share is calculated by dividing the fund's NAV by the number of outstanding shares.
Mutual fund investors don't actually own the underlying holdings—the stocks or bonds—that have been purchased by the fund. Rather, they benefit from owning shares of the fund that owns those holdings whenever the values of the holdings increase.
Types of Mutual Funds
There are countless mutual funds in the investment universe, but they can be divided into four basic categories:
- Stock funds: As the name suggests, these funds invest in company stocks.
- Bond funds: These funds are invested in bonds and other debt securities.
- Money-market funds: These invest in quality short-term government securities.
- Target-date funds: These funds are appropriate for investors with a specific retirement date in mind, which typically appears in the name of the fund.
From there, the categories of funds get more specialized. For example, stock funds may be further categorized as growth funds, which emphasize stocks with above-average returns; income funds, which refer to dividend-producing funds; index funds, which seek to produce similar returns as an index like the S&P 500; or sector funds, which focus on a certain market sector such as health care.
Some mutual funds choose to focus on producing income from dividends, payments made by companies to their shareholders, rather than seeking gains in stock prices.
Pros and Cons of Mutual Funds
The main benefits of mutual funds are:
- Simplicity: Most investors don't have the knowledge, time, or resources to build their own portfolio of individual stocks and bonds from scratch. However, buying shares of mutual funds enables investors to benefit from a professionally managed, diverse portfolio even if they have little or no knowledge of investing concepts and strategies.
- Diversification: All investors, beginners and pros alike, should know that proverbially putting all of their eggs into one basket—keeping all of their money in a single type of investment—is unwise. That old saying makes the case for investment diversification with mutual funds. To diversify with individual stocks, an investor might need to buy many securities. However, a few or even one broadly themed mutual fund can offer a great deal of diversification. For example, an index fund can provide exposure to all the stocks in a major market benchmark.
- Versatility: The many types of mutual funds allow investors to gain access to almost any segment of the market imaginable. For example, sector funds make it possible for investors to buy into focused areas of the stock market. Investors can also get exposure to commodities such as gold and other precious metals or oil and natural gas by investing in a fund that buys shares in companies that produce those commodities. This versatility can be used to produce further diversification as an investor's portfolio of mutual funds grows.
- Accessibility: Mutual funds are easily purchased indirectly through an online brokerage account or directly from the investment company that offers the fund. Although many mutual fund firms require a minimum investment, you can start buying mutual fund shares with a low or even no minimum in certain circumstances. For example, Fidelity has no minimum initial investment on its index mutual funds, and TIAA waives it's usual $2,500 minimum investment if you set up an automatic share purchase plan, with money taken from your bank account once or twice a month.
The downsides of mutual funds include:
- Investment risk: Stocks, bonds, and the mutual funds that invest in them all involve some level of risk, which is the possibility of a decline in value, or, in a worst-case scenario, the total loss of principal—your initial investment. Different mutual funds come with different types of risk. For example, stock funds are riskier in general than bond funds, and come with a high degree of market risk in particular, referring to the potential for wild upswings and downswings in stock prices. Bond funds are perceived as riskier than money-market funds and often come with credit risk, which is the risk that the companies that make up your fund will default on their debts. Before you invest, determine your risk tolerance and invest accordingly.
- Fees: From sales charges to management fees, a mutual fund can become an expensive proposition if you're not careful about which one you buy. These fees can eat into your investment returns, so look for funds with no sales charges or transaction fees and an expense ratio (operational expenses divided by average net assets) that's at or below the average (45% in 2019) to maximize your returns.
- Less control: A mutual fund doesn't grant investors as much control over the underlying securities they hold as they would if they were to buy securities individually.
- Tax inefficiency: If you hold mutual funds in a taxable investment account such as a brokerage account, you could be on the hook to pay taxes on investment earnings (for example, dividends from an income fund). A simple way to overcome this is to keep mutual funds in tax-advantaged accounts like IRA accounts.
Take your investment time horizon into consideration when determining what types of funds to purchase. If you won't be retiring for many years, you are often encouraged to put a lot of your money in stock funds. As you get closer to retirement, it may make sense for you to become more financially conservative and shift money out of stocks and into bonds.
Mutual Fund vs. ETF
Exchange-traded funds (ETFs) are sometimes confused with mutual funds because they also allow investors to pool money to buy into various securities and are typically managed professionally.
The key difference is that retail or everyday investors can't buy ETF shares directly from an ETF as they can from a mutual fund; only authorized participants such as financial institutions can buy ETFs directly, which is done through national stock exchanges, and not necessarily at the NAV price of the ETF. They usually buy large blocks of shares, and afterward, sell ETF shares to investors on the secondary market. Here, trades may be executed throughout the day for ETFs compared to only once per day for mutual funds. This makes them more suitable for individuals who want to trade more frequently. When funds are held in taxable accounts, ETFs tend to result in lower taxes than mutual funds because some ETFs can be redeemed in kind.
|Investors can buy shares directly from the fund||Investors may only buy shares on a secondary market|
|Execute trades once a day||Execute trades throughout the day|
|Typically results in greater tax liability||Results in lower taxes|
- A mutual fund represents a pool of money invested in a portfolio of different securities.
- Mutual funds can be purchased directly from the investment fund or through a broker.
- The main types of mutual funds are stock funds, bond funds, money-market funds, and target-date funds.
- Although mutual funds enable diversification and versatility in the market sectors to which an investor is exposed, some funds can be costly, and keeping them in a taxable account can increase the financial burden.
- ETFs present an alternative to mutual funds but must be purchased on the secondary market, and are suitable for more active traders.