Understanding how mutual funds work

What are mutual funds? 

A mutual fund is an investment company that sells shares. It takes the money it receives from selling shares and uses it to invest in securities, like stocks or bonds. 

Each investor in the mutual fund owns a part of the fund’s portfolio that’s proportional to the shares they hold. If you buy more shares, you get a larger stake in the fund’s holdings.

“I think of it as a bowl of Skittles where you have all the different colors, each color representing a company, and you’re buying basically a little bit of that bowl,” says Andrew Aran, CFA, and managing partner at Regency Wealth Management.

How mutual funds work

A professional manager oversees a mutual fund’s portfolio and makes decisions about which assets to buy and sell, according to the overarching goals of the fund. Mutual fund companies set goals in their prospectus, which is a document that summarizes information about an investment opportunity. A mutual fund might aim to invest in securities that will increase in value or to generate income for investors.

Mutual funds are typically open-end funds, which means that they constantly sell new shares and buy back previously issued shares. There’s no deadline for buying shares, and you don’t have to wait until a specified date to sell back your shares, as would be the case with a closed-end fund.

Mutual funds sell their shares directly to the public, or you can buy shares through a brokerage or an investment adviser.

A mutual fund’s shares aren’t always alike. Mutual funds can sell different classes of shares, and the mix of fees and expenses varies depending on which class you buy. “The higher dollar amounts that you’re willing to invest, the more advantageous fee schedule you’ll end up getting,” says Michael Becker, CFA, and investment analyst at Hightower Wealth Advisors in St. Louis.

Mutual funds update their share price once per business day, typically at 4 p.m Eastern Time. To do this, they calculate their net asset value (NAV), which is their total assets minus their total liabilities. They divide this value by the number of shares to find the net asset value per share. 

Investors who buy shares pay the NAV per share plus any applicable fees, and investors who sell shares receive the NAV per share minus fees.

After determining their new share price, mutual funds go through the orders to buy and sell shares that investors submitted earlier that day and fulfill them at the updated price. So if you want to redeem shares for cash and you put in the order at 9:00 a.m. Eastern Time, the transaction won’t actually go through until after 4 p.m Eastern Time. And you won’t know the price until that happens. After you redeem shares, the mutual fund typically sends you the money within seven days.

There are a few different ways investors can earn a return on their mutual fund shares.

For one, the underlying securities in the fund’s portfolio might pay dividends, which flow through the fund to its shareholders. Or, the fund might sell some of its securities at a profit, generating capital gains. You generally can choose if you want the fund to write you a check for dividends and capital gains distributions or if you want to automatically reinvest them in the fund.

And if the fund’s share price goes up, you can earn a return by selling shares for more than you paid for them (i.e., capital gains).

Mutual fund fees

Mutual funds cover the costs of doing business by charging fees and tapping into fund assets. Here are the main fees associated with mutual funds:

• Management fees and distribution fees: Management fees are used to pay the fund’s investment adviser, and distribution fees cover the costs of marketing and selling shares. These fees—and other expenses like accounting costs—contribute to a fund’s operating expense ratio, which is a fund’s annual operating costs expressed as a share of its assets. “It’s not where you’re charged a fee like a debit,” says Maria Bruno, Head of U.S. Wealth Planning Research at Vanguard. “It’s actually priced into the NAV of the fund.” This ratio is typically a fraction of a percent.
• Sales load, also called a sales charge: These fees pay the brokers who sell a fund’s shares. You may pay a front-end load when you buy shares or a back-end load when you redeem shares for cash. A load can’t be more than 8.5% of the transaction amount. Some funds don’t charge loads, but you still pay operating expenses and other fees.
• Redemption fees: These fees pay the fund for the costs of redeeming shares. They can’t be more than 2%.
• Exchange fees: You may pay these fees if you sell shares in a fund and buy shares in another fund in the same group.
• Account fees: Funds may charge account fees if your account’s value falls below a set threshold. 
• Purchase fees: These fees pay the fund for the costs of purchasing shares.

What are the different types of mutual funds? 

There’s a vast range of different mutual funds out there. Each type of fund invests in a particular asset class or has a specific objective.

First, funds can be defined by what they invest in. “Basically anything that you can imagine can end up in a mutual fund,” says Becker. Here’s a breakdown of the various types of funds out there:

• Equity funds: These funds invest in stocks. They might focus on companies in the U.S. or throughout the world, and they can hold as little as 20 stocks or more than 1,000.
• Money market funds: These funds invest in low-risk, short-term debt like U.S. Treasury securities. They aim to pay better than a savings account. Often, you can write checks to withdraw money from your account.
• Bond funds: These invest in bonds and may specialize in a particular type, like corporate bonds or municipal bonds. Funds that invest in government-issued bonds sometimes generate tax-exempt interest payments.
• Commodity funds: These invest in stocks of companies that produce resources or materials or in futures contracts, which are agreements to buy or sell resources in the future. Some invest in a mix of both.
• Alternative funds: These often invest in less standard assets like private debt or foreign currencies. They may use complex strategies and sometimes come with high fees.
• Asset allocation funds: These funds split their portfolios between different asset types, like stocks and bonds. They regularly rebalance, which means that they adjust the ratio of different securities they hold so that they maintain the desired mix of assets.
• Target date funds: These are a form of asset allocation fund. They start out with a high percentage of securities with good growth potential but higher risk, then shift their holdings over time to give more weight to safer investments. The idea is to allow investors to prepare for a future event, like retirement, buying a home, or paying college tuition.
• Growth funds: These funds aim to maximize capital gains. They invest in companies whose shares are expected to go up in value, even if they don’t pay dividends.
• Income funds: These prioritize dividends or interest and seek to produce income for investors. Fixed income funds aim to give investors a steady level of income on a set schedule.
• Inverse funds: These try to go up when the market is down using complex and risky strategies. Their value may change quickly, and they typically are meant to be held for a short time only.
• ESG funds: These invest based on environmental, social, and governance factors. They seek to invest in companies that have a positive impact on society or the natural world, and they may also consider traditional financial factors when selecting investments.

Actively managed mutual funds vs. index mutual funds

Mutual funds can also be categorized as index funds or actively managed funds.

Index funds try to create a portfolio that earns the same returns as an index, or a standard list of securities. An index fund might buy every stock in an index, or it might buy a representative group. “There’s no portfolio manager making active picks, meaning he or she’s not evaluating the underlying companies to see which one they like better or worse,” explains Rick Nott, CFA, and senior wealth advisor at LourdMurray.

Instead, index fund managers buy whatever’s in the index. They don’t research the companies they invest in or try to determine which stocks are good picks, because they want to create a portfolio that tracks the index as closely as possible. As a result, index fund costs are typically low—in some cases, just 0.03% to 0.04% of the money invested in the fund.

Actively managed funds try to outperform an index by giving more weight to investments expected to go up in value. “Their express goal is to do better than the list of general stocks within that asset class. So rather than buying the S&P 500, for example, you can buy someone who believes they can beat the S&P through their skill or knowledge,” says Nott.

Active managers count on the market overlooking some good investments, at least temporarily. They try to swoop in and buy undervalued stocks before share prices rise.

Active managers rely on their own research and judgment calls, and they turn over their holdings more frequently. “They’re constantly making buy and sell decisions,” says Bruno. She adds that neither actively managed funds nor index funds are inherently better but that whichever you choose, you need to pay attention to the costs.

Once you account for the costs of intensive management, the returns on actively managed funds are often unimpressive. In a typical year, less than half of actively managed funds outperform the index. Still, some active managers successfully beat the market. It could be worth it to pay higher fees on an actively managed fund if it consistently picks winning stocks. 

Pros and cons of mutual funds 

Mutual funds offer benefits that come with professional management, but you give up direct control over your investment.

Pros

Convenience: Mutual funds offer an accessible way  to invest. You can select them in most 401(k) plans, and they’re easy to buy and sell. You can set up automatic investments and buy shares in a fund without even needing to remember to click a button from time to time.

Professional management: Mutual funds allow investors who don’t have a lot of money to benefit from expert oversight of their portfolio.. 

Diversification: Buying shares in a mutual fund can get you exposure to a large market, so your investment isn’t riding on the success of any particular company. Mutual funds give you broad diversification, meaning that you hold many different assets rather than a few. In a diversified portfolio, each security makes up a small part of the whole. 

While diversification doesn’t ensure you won’t lose money, it leaves you far less vulnerable in case one of your investments goes down in value. If a rogue CEO tanks their company’s reputation, for example, you could lose everything if you hold only that one company and its price goes to zero. “In a mutual fund, you’re buying maybe as little as 30 different stocks, but as many as a thousand different stocks. And so no two stocks typically move in the same direction,” Nott says. It’s highly unlikely that the prices of all those securities would plummet to nothing at the same time. 

Can deter panic selling: Mutual funds might encourage investors to stay the course with a buy-and-hold strategy. Because mutual funds are traded only once a day, you can’t sell them off in a panic the second a bad jobs report hits the markets, for example. Knowing that you’re subject to a delay might prompt you to take some time to consider your options. “That dynamic is important from a psychological standpoint for investors,” says Nott. 

Cons

Delayed trading: On the flipside of the last point above: The fact that trading isn’t instantaneous can be a negative. Until the market closes for the day, you don’t really know what price you’re paying.

Fees: If you buy a security without going through a fund, you don’t have to pay a fee to hold onto it. But if you invest in a mutual fund, you have ongoing costs, which were outlined above. What’s more, investors aren’t always aware of all the fees they’re paying. 

Lack of transparency: Mutual funds’ investing tactics and philosophies can be opaque, especially for people who aren’t well-versed in finance. “That can be a problem if the underlying manager of the mutual fund tries to take too much risk and clients cannot be totally informed on the ways that they’re taking those risks,” says Becker.

Surprise tax bills: Tax planning is another area where mutual funds have drawbacks. “If you own a stock, say, you can decide when to buy it or sell it. You know what you paid for it. You know what it’s trading for. You know what the potential gain or loss is. In the mutual fund, you don’t have control over that. Managers do,” Aran says. “You lose that ability to manage your tax picture if you own a mutual fund.”  

Expensive account thresholds: And although mutual funds are fairly accessible, they’re still out of reach for some investors because of how costly they can be to buy and trade. For example, you often need to meet an account minimum of a few thousand dollars to get started.

Are mutual funds a good investment? 

Mutual funds can be a good investment, but it depends on how much money you can afford to invest.

“For larger investors, it’s less efficient or attractive because of the expense structure,” Aran says. “Now, if you buy a group of 40, 50, 60 stocks, you can accomplish pretty good diversification and save the fees on the underlying mutual fund.” 

For those with less capital to invest or less experience, mutual funds offer an off-the-shelf product that makes investing easy. “You don’t have to worry about picking and choosing and rebalancing. There are a lot of funds that can do that for you,” says Bruno.

The wide array of available mutual funds means that there’s a fund out there to match just about any objective. The flip side of that abundance, though, is that you have to sort through numerous options. “There are some mutual funds that can suit clients’ needs to a tee, and there are also some funds that really don’t fit any client’s needs,” Becker says.

The takeaway 

Mutual funds provide a way to access professional investment management and to gain broad market exposure in one investment vehicle. These funds vary widely in their strategies and in the risks they take, and you should understand what a fund is doing before buying shares. You also need to consider if the benefits of investing in a fund are worth the fees.