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A mutual fund pools money from many investors and builds a portfolio of stocks, bonds or other securities. Mutual funds provide excellent diversification and professional management, making them a great choice for most regular investors.
Understanding Mutual Funds
A mutual fund is a financial company that sells shares to investors, and then invests the proceeds in securities like stocks, bonds, derivatives and short-term debt. The combined holdings, which can comprise hundreds of securities, make up the mutual fund’s portfolio.
Professional investors spend a great time picking stocks and bonds to create well-balanced investment portfolios. It’s a challenging job that requires expertise and plenty of research to get it right. Mutual funds make this sort of expert management available to regular investors, for a reasonable fee.
If you’re saving for retirement in a 401(k) or individual retirement account (IRA), you may already own one or more mutual funds. According to a 2021 study from the Investment Company Institute, about 45% of U.S. households own a mutual fund.
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Mutual Funds and Diversification
Mutual funds are utilized by novice and professional investors alike to pursue longer-term goals. Compared with other investment options, mutual funds are a popular choice because they provide easy diversification.
You could choose to buyindividual stocksand build your own diversified portfolio. However, you would have to buy dozens of companies, monitor their performance and adjust your holdings regularly to keep up with the changing market.
When you buy shares in one mutual fund, you’re investing in many companies and market sectors at once. By purchasing a mutual fund, you own a piece of the fund’s overall portfolio.
For example, if a mutual fund owns 100 stocks, and you invest $1,000 in that fund, you own about $10 worth of each stock—minus any fees.
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How Do Mutual Funds Work?
Each mutual fund share represents an investor’s partial ownership of the fund. If the fund experiences profits or losses, they are shared among all of the fund’s investors.
A mutual fund can earn dividends and interest from its holdings. Depending on the fund, the fund manager may opt to reinvest the profits or distribute them to investors. If the fund generates losses, then it’s also shared across investors.
Choices made by other investors can affect the fund’s performance. If mutual fund holders decide to sell their shares, the fund manager may have to liquidate some of the fund’s holdings to make them whole. If enough investors sell around the same time, the fund can incur losses.
Mutual funds also differ from some other securities in terms of their fees, management styles and net asset value.
Mutual Funds and Net Asset Value (NAV)
Net asset value (NAV) represents a mutual fund’s total assets—all of the cash and securities in the fund’s portfolio minus any liabilities or debt—divided by the number of outstanding shares.
Unlike individual stocks, where prices can fluctuate by the minute, mutual funds’ NAV is calculated only once per day, at the end of each trading session at the market’s close.
NAV can also be referred to as the fund’s closing price because all orders to buy and sell mutual fund shares are executed at the price determined at the end of the trading day.
Mutual Fund Fees
Mutual funds charge fees, which can have a major impact on the returns you see on your investment. There are three primary types of fees:
- Expense ratio. The annual fee that all mutual funds charge is based on a percentage of the fund’s assets. As of 2020, the average expense ratio for equity mutual funds was about 0.5%.
- Load fee. This is a form of sales charge or commission. The load fee is assessed when you buy or sell shares of a mutual fund. No-load mutual funds do not charge load fees.
- 12b-1 fee. An annual marketing and distribution expense charged by a mutual fund is also expressed as a percentage of assets.
No-load mutual funds are increasingly common. In fact, 88% of gross sales of mutual funds in 2020 went to no-load funds without 12b-1 fees.
Mutual Fund Management
Part of a mutual fund’s appeal is that it’s professionally managed. Investment teams set the fund strategies, make trades and monitor the fund’s performance. However, management styles differ from fund to fund, and the choices made by managers have a direct impact on your returns.
There are two primary types of mutual fund management styles: active and passive funds.
- Active management. With an actively managed mutual fund, a team of professionals pick and choose the fund’s investments. Their goal is to beat a market benchmark by actively trading securities based on their research, market models and professional judgment. Actively managed funds tend to have higher expense ratios than passive funds; the average expense ratio for actively-managed funds was 0.71% in 2020.
- Passive management. While actively managed funds aim to outperform the market, passively managed index funds aim to replicate benchmarks like market indexes. Passive funds tend to have lower operating costs than actively managed funds, and have been proven to deliver consistent returns.
According to the Financial Industry Regulatory Authority (FINRA), actively-managed funds may have impressive short-term performance records. However, FINRA cautions that most actively-managed funds aren’t successful at outperforming the market long term.
Mutual Funds vs. ETFs
For investors looking to build diversified portfolios, mutual funds and exchange-traded funds (ETFs) are two popular options since they both contain professionally-managed collections of stocks or bonds, but there are some key differences between the two.
Mutual funds and ETFs are both less risky than investing in individual securities. ETFs tend to have lower investment minimums, while mutual funds have less trading flexibility but are good for those that want to take advantage of automatic investments.
The main difference between mutual funds and ETFs is in how they are traded. Mutual funds have less trading flexibility since they are bought and sold through brokers at the end of the trading day. By contrast, ETFs can be bought and sold throughout the day on stock exchanges.
How to Invest in Mutual Funds
If you have a retirement account through an employer, such as a 401(k), you may already have access to mutual funds.
If you don’t, you can open a brokerage account and invest in mutual funds with a traditional individual retirement account (IRA) or other investment accounts. But how do you decide which mutual funds to invest in? Here’s what you need to know.
How to Choose a Mutual Fund
When comparing mutual funds, there are several key factors to consider, such as investment objective, management style and fees.
- Investment objectives. The investment objective is what the fund is trying to achieve. For example, some funds aim to generate income while others focus on growth or capital preservation.
- Management style. There are two primary types of mutual funds: actively managed and passively managed. With an actively managed fund, a team of investment professionals actively manages the fund by buying and selling securities. A passive fund seeks to track an index, such as the .
- Fees. All mutual funds charge fees, which are used to cover the costs of managing and administering the fund. However, fees can vary a great deal between funds.
- Past performance. A mutual fund’s past performance isn’t indicative of future success, but it can give you an idea of how the fund has performed relative to market indices over time.
All of this information should be included in the mutual fund’s prospectus. You can find each fund’s prospectus on the fund company’s website, or you can search for the prospectus on the U.S. Securities & Exchange Commission (SEC) database.
If you need help understanding the available information, Morningstar offers a handy course on prospectuses.
How to Discover and Compare Mutual Funds
To find mutual funds to invest in and research their performance, view a list of available funds through your retirement plan’s website. If you’re investing on your own in a taxable brokerage account or IRA, you can contact the broker to find out what mutual funds are available.
Once you’ve narrowed down your list of options, you can use FINRA’s mutual fund analyzer tool to compare how the funds’ fees and expenses may affect the account value over time.
Mutual Fund FAQs
How are mutual funds taxed?
If you own shares of mutual funds, you’re responsible for reporting mutual fund distributions. Whether the fund’s distributions are reinvested in additional shares or issued as cash, you must pay taxes on mutual funds, including on any capital gains or dividends.
As an investor, your taxes can become complicated. If you aren’t sure how to handle your taxes, consult a tax professional.
How many mutual funds should I have?
When considering how many mutual funds to invest in, you should know there’s no one right answer. Some investors may feel comfortable investing in just one broad market mutual fund, while others may utilize a dozen or more.
In general, look for diversification of funds. For example, instead of investing in multiple large-capitalization funds—which could mean redundancy in your portfolio, invest in one large-cap, one mid-cap and one-small cap fund. You may also want to invest in an international mutual fund as well as a domestic fund.
What is the best mutual fund?
The best mutual fund is dependent on your investment goals and risk tolerance. To help you find mutual funds that fit your goals, we have researched leading options and identified the best mutual funds.
