What Is a Mutual Fund?

Investing, Investments
What Is a Mutual Fund?

Quick facts about mutual funds

  • They pool money from multiple investors to invest in a variety of individual stocks, bonds or other securities
  • They’re a good way to minimize risk because they spread your money across a diverse, managed set of investments
  • They give investors access to a broad range of investments that would otherwise be unaffordable
  • They cater to a variety of risk tolerances 

Most people don’t have the time, expertise or deep pockets to build a diversified portfolio one investment at a time. Mutual funds can help.

A mutual fund pools money from multiple investors — often thousands — to invest in a range of stocks, bonds and other assets. Investors buy shares in the fund, which charges a fee for managing the investments inside it. These fees are fixed, but the returns are variable and — as with all investments — it is possible to gain or lose money.

Mutual funds are considered a good way to balance risk across a range of investments that might otherwise be out of your financial reach.

Key things to know about mutual funds

Management of a mutual fund can be active or passive. Actively managed funds are run by professionals who often are trying to beat the market. Passively managed funds, such as those offered by robo-advisors, instead follow a predetermined strategy, hoping to mimic the performance of the market. Actively managed accounts have higher fees — called expense ratios — than passive funds.

» MORE: What is a robo-advisor?

There are a wide variety of mutual funds with varying levels of risk and return. Here are some of the basics, starting with the least risky:

  • Money market funds invest in high-quality, short-term debt issued by the U.S. government or corporations. Your return might not be much better than what you’d get with a savings account at a bank.
  • Income funds also invest primarily in government and high-quality corporate debt, but their main objective is to provide a steady flow of income to investors. Retirees and conservative investors might be interested in these.
  • Bond funds invest in, well, bonds, and their risk level depends on the creditworthiness of the bond issuers. Government equals good; shady company equals less good.
  • Hybrid, or balanced, funds invest in a blend of stocks, bonds and other securities, aiming to provide a solid mix of profit and security. Many hybrid funds are “funds of funds,” meaning they invest in other mutual funds.
  • Equity funds invest in individual company stocks and carry the greatest risk, as well as the greatest potential returns. Market fluctuations can drastically affect your gains or losses.

Other funds are notable less for what’s inside them than for certain features:

  • Index funds track a market index, such as the Standard & Poor’s 500 or the Nasdaq. These types of funds are made up entirely of the stocks comprising a particular index, so the risk mirrors that of the market, as do the returns.
  • Exchange-traded funds can be traded like individual stocks but also offer the diversification benefits of mutual funds. They generally charge lower fees than traditional mutual funds, but active traders might find their costs too high.

What’s in it for you?

Mutual funds can make cash in three ways: when a fund receives dividends or interest on the securities in its portfolio and distributes a proportional amount to its investors; when a fund sells a security that has gone up in price; and when the net asset value of a fund — and thus, your shares — increases.

Mutual funds create an economy of scale. Buying a broad range of stocks and bonds would break the bank of the average American. Mutual funds pool the cash of thousands of investors, giving them a cost-effective way to benefit from gains in the market.

Mutual funds are a potent tool for diversifying retirement savings. By pooling resources, mutual funds also spread risk and give people greater choice among conservative and riskier investments, as well as a broader mix of industries and asset classes.

Other resources explaining mutual funds and their role in your portfolio:

Kevin Voigt is a staff writer at NerdWallet, a personal finance website. Email: kevin@nerdwallet.com. Twitter: @kevinvoigt.