Mutual Funds: What They Are and How They Work

What is a mutual fund?

Mutual funds are a type of investment that pools together money from many investors, then uses that money to mutually invest in stocks, bonds or other assets. Mutual funds are typically managed by a professional who selects the investments for the fund.

By allowing investors to buy into many investments with a single purchase, a mutual fund can help build more diversified portfolios than most investors could build on their own. Index funds, bond funds and target date funds are all types of mutual funds.

Mutual fund investors don’t directly own the stock or other investments held by the fund, but they do share equally in the profits or losses of the fund’s total holdings — hence the “mutual” in mutual funds.

» Learn how to invest in mutual funds

Active vs. passive mutual funds

A mutual fund's fees and performance will depend on whether it is actively or passively managed.

Passive mutual funds

Passively managed funds invest to align with a specific benchmark. They try to match the performance of a market index (such as the S&P 500), and therefore typically don’t require management by a professional. That translates into lower overhead for the fund, which means passive mutual funds often carry lower fees than actively managed funds.

» Ready to invest? View the best brokers for buying mutual funds

Here are two types of mutual funds popular for passive investing:

Index funds are made up of stocks or bonds that are listed on a particular index, so the risk aims to mirror the risk of that index, as do the returns. If you own an S&P 500 index fund and you hear that the S&P 500 was up 1% for the day, that means your index fund should be up about that much, too.

Exchange-traded funds can be traded like individual stocks, but offer the diversification benefits of mutual funds. In many cases, ETFs will have a lower minimum investment than index funds. ETFs may be more tax-efficient than index funds.

Active mutual funds

Actively managed funds have a professional manager or management team making decisions about how to invest the fund's money. Often, they try to outperform the market or a benchmark index, but studies have shown passive investing strategies often deliver better returns.

Categories of mutual funds

Beyond the active and passive designations, mutual funds are also divided into other categories. Some mutual funds focus on a single asset class, such as stocks or bonds, while others invest in a variety. These are the main types of mutual funds:

Stock (equity) funds

Typically carry the greatest risk alongside the greatest potential returns. Fluctuations in the stock market can drastically affect the returns of equity funds. There are several types of equity funds, such as growth funds, income funds and sector funds. Each of these groups tries to maintain a portfolio of stocks with certain characteristics.

» View the best mutual funds this month

Value funds

Equity funds that seek to invest in companies that are determined to be undervalued based on the company's fundamentals.

Balanced funds

Balanced mutual funds invest in a mix of stocks, bonds and other securities. Balanced funds (also called asset allocation funds or hybrid funds) are often a “fund of funds,” investing in a group of other mutual funds. One popular example is a target-date fund, which automatically chooses and reallocates assets toward safer investments as you approach retirement age.

Blended funds

These include a mix of value and growth stocks, or those that offer strong earnings growth.

Bond (fixed-income) funds

Bond funds are typically less risky than stock funds. There are many different types of bonds, so you should research each mutual fund individually in order to determine the amount of risk associated with it. (View our list of the best-performing bond ETFs.)

Money market funds

These products often have the lowest returns because they carry the lowest risk. Money market funds are legally required to invest in high-quality, short-term investments that are issued by the U.S. government or U.S. corporations.

» Learn more: Understand the different types of mutual funds

How do mutual fund profits work?

When you buy into a mutual fund, your investment can increase in value in three ways:

1. Dividend payments

When a fund receives dividends or interest from the securities in its portfolio, it distributes a proportional amount of that income to its investors. When purchasing shares in a mutual fund, you can choose to receive your distributions directly, or have them reinvested in the fund.

2. Capital gains

When a fund sells a security that has gone up in price, this is a capital gain. (And when a fund sells a security that has gone down in price, this is a capital loss.) Most funds distribute any net capital gains to investors annually. In a year with high capital gains payouts, investors may see a large tax bill, especially high-net-worth individuals who will pay higher capital gains tax rates.

3. Net asset value

Mutual fund share purchases are final after the close of market, when the total financial worth of the underlying assets is valued. The price per mutual fund share is known as its net asset value, or NAV. As the value of the fund increases, so does the price to purchase shares in the fund (or the NAV per share). This is similar to when the price of a stock increases — you don’t receive immediate distributions, but the value of your investment is greater, and you would make money should you decide to sell.

» Need to run the numbers? Check out our mutual fund calculator.

Mutual fund pros and cons

Mutual funds are a solid investment option, which is why they are used so widely. They have many pros — but that doesn't mean they don't come with a few cons, or things to watch out for.

Pros

These are the primary benefits to investing in mutual funds:

• Simplicity. Once you find a mutual fund with a good record, you have a relatively small role to play: Let the fund managers (or the benchmark index, in the case of index funds) do all the heavy lifting.

• Professional management. Active fund managers make daily decisions on buying and selling the securities held in the fund — decisions that are based on the fund's goals. For example, in a fund whose goal is high growth, the manager might try to achieve better returns than that of a major stock market like the S&P 500. Conversely, a bond fund manager tries to get the highest returns with the lowest risk. If you're interested in (and willing to pay for) professional management, mutual funds offer that.

• Affordability. Mutual funds often have a required minimum from $500 to $3,000, but several brokers offer funds with lower minimums, or no minimum at all.

• Liquidity. Compared with other assets you own (such as your car or home), mutual funds are easier to buy and sell.

• Diversification. This is one of the most important principles of investing. If a single company fails, and all your money was invested in that one company, then you have lost your money. However, if a single company within a mutual fund fails, your loss is constrained. Mutual funds provide access to a diversified investment without the difficulties of having to purchase and monitor dozens of assets yourself.

Cons

Here are the major cons of mutual funds:

• Fees. The main disadvantage to mutual funds is that you'll incur fees no matter how the fund performs. However, these fees are much lower on passively managed funds than actively managed funds.

• Lack of control. You may not know the exact makeup of the fund's portfolio and have no say over its purchases. However, this can be a relief to some investors who simply don't have the time to track and manage a large portfolio.

Mutual funds vs. ETFs vs. stocks

With so many different types of investments out there, it can be difficult to choose which ones are right for you. Here is a quick comparison between three of the most popular types of investments.