What Are Mutual Funds and How Do They Work?

FT Contributor  | 

A mutual fund is both an investment product and a company that manages investments — not to be confused with index funds or other types of stocks. There many nuances surrounding mutual funds, but ultimately the goal is to leverage professional teams to make money through investing.

Mutual Funds Definition

Mutual funds are professionally managed investments that gather money from multiple investors to make company-related purchases. If you invest in mutual funds, you’re pooling your investment money with other investors to purchase certain stocks, bonds, and other securities, also referred to as a “portfolio.” With professional management, a small buy-in, and easy diversification, mutual funds are a popular investment vehicle for retirement.

The price you pay for the mutual fund, also known as its net asset value (NAV), is calculated by taking the total value of all the securities in the portfolio and dividing it by the number of outstanding shares in the fund. Therefore, this price fluctuates with the stock market and can be different at the close of each day. As a mutual fund investor, you don’t actually own the securities in which the fund invests, but only the shares themselves.

A mutual fund can be considered both a company and an investment. The mutual fund itself is a representation of the value of the company. Therefore, when you buy mutual funds that represent stock in ABC Company, you’re actually buying part ownership of ABC Company and its assets.

How Do Mutual Funds Work?

It’s important to understand that owning mutual funds is different from owning stock in the company itself. With a mutual fund, you are not given voting rights with the company. Since the shares in your mutual fund may represent several different securities, you can obtain diversification in your portfolio without making hundreds of small and specific investments.

Index funds and mutual funds are similar in that they both allow you to diversify your portfolio. However, index funds generally focus on one specific index in the stock market. If you want an incredibly diverse portfolio, you may want to stick with mutual funds.

Returns

There are many ways you can gain returns on a mutual fund, depending on the type of investment you’ve made.

  • Dividend Payments. You’ll receive dividend payments if your mutual fund earned income from dividends on stock or received interest on bonds.
  • Capital Gains. When a fund sells a security after a price increase, it earns capital gains. These gains are distributed to all fund investors at the end of the year, after factoring in any capital losses.
  • Increases in the NAV. When the market value of the portfolio increases, even after expenses are deducted, the value of the fund and shares also increase. A higher NAV means the value of the investment has also increased.

Active vs Passive Management

When investing in mutual funds, you may have a choice between active or passive management of your investments. To make the right choice for your situation, you must determine if you want to keep your portfolio invested long-term or short-term.

Active Management Basics

With active management, your portfolio manager will make moves and react to price fluctuations in the market quickly and aggressively. Since this type of management requires constant surveillance and expertise to know the exact moments to buy and sell, it is associated with higher management fees.

If you don’t want to invest your mutual funds for a long period of time and know you’ll cash out on your returns shortly, this aggressive strategy may pay off. Active management is riskier because you don’t have as much time to make a profit. Depending on the market’s behavior, you could either see great returns, or you could lose money with this strategy.

Passive Management Basics

You may opt for a passive management strategy if you’re investing for the long-term. With this strategy, your portfolio manager is more conservative when making buying and selling decisions. The goal for passive management is to ensure your mutual funds provide returns in several years instead of right away.

While your portfolio manager will keep an eye on your portfolio performance, he or she may allow your investments to fluctuate in order to make returns in the future. Since this strategy doesn’t require as much monitoring and prediction, the management fees are much lower. This type of management is associated with less risk but also usually with smaller returns.

Examples of Common Types of Mutual Funds

You may wonder which are the best mutual funds and what the risks or rewards associated with these investments are. There are many types of investments that fall within the spectrum of mutual funds. However, most mutual funds generally fit into one of four categories explained below.

Money Market Funds

Money market funds are different from money market savings accounts offered through banks. With money market mutual funds, you purchase a pool of securities that provide higher returns than the interest you would gain by simply placing your money in a bank account. Money market funds are increasing in popularity because there are many different types, which can cater to different investors and their needs.

These funds can invest primarily in corporate and bank debt securities, government securities, or tax-exempt municipal securities, depending on the type of funds purchased. Money market funds are associated with low risks because they must be invested in specific short-term, high-quality investments. These may include only U.S.-based corporations or federal, local, and state governments.

Bond Funds

These types of mutual funds invest in bonds and other debt securities. They have higher risks than money market funds but they are also set up to offer potentially higher returns. Since there are many different types of bond funds, the risks and returns associated with them can vary greatly.

Stock Funds

Stock funds are mutual funds that invest in corporate stocks. These funds are aimed at long-term growth through capital gains. However, some stock funds may achieve returns through dividends. There are many types of stock funds and some may be focused on certain sectors of the market while others may differ based on the level of risk involved in the investment.

Target Date Funds

A target-date fund (TDF) is also referred to as a lifecycle, dynamic-risk, or age-based fund. It holds a mix of stocks, bonds, and other investments that shift gradually toward the strategy of the fund. These types of mutual funds are best for investors who are nearing retirement age since they become more conservative as the retirement date approaches.

Mutual Fund Costs

It’s important to note that mutual funds are associated with fees. As an investor, you are charged fees to invest in mutual funds because your portfolio requires professional management. These fees can be charged as transactional fees, redemption fees, or fund operating fees.

Sales Loads

Sales loads are fees you must pay as an investor when your mutual funds are bought or sold.

Redemption Fee

You may be charged a redemption fee on your mutual funds if you only owned the funds for a short period of time.

Exchange Fee

An exchange fee is charged when there is an exchange in funds that took place within the same investment company.

Account Fee

Similar to how a membership fee is charged at a club, an account fee is charged to your mutual fund account to maintain the portfolio.

Purchase Fee

Separate from the sales load fee, the purchase fee is charged at the time of the mutual fund purchase.

Are Mutual Funds Safe?

Like any investment you make, mutual funds are associated with risk, reward, and unpredictability. The types of mutual funds you invest in, the investment strategy you choose, and the length of time you invest for can affect the amount of risk you take and the return you’re likely to experience.

Risks

The risks associated with your portfolio depend on the types of mutual funds you’ve invested in and the underlying assets. For example, the risks you may encounter when investing in bond funds include certain interest, prepayment, or credit risks. TDFs are associated with risks including asset allocation changes, variation of investment funds, and the effects of a conservative strategy on returns.

Benefits

Allowing an experienced investment advisor to monitor your securities changes the way these investments perform. With professional portfolio management, an expert makes calculated moves to ensure your mutual funds are performing as best they can. It’s easy for your portfolio manager to buy and sell mutual funds and this liquidity can lead to higher returns for you in the long run.

There are many types of mutual funds and a variety of offerings you can add to your portfolio. This type of investment allows you to diversify your assets in a simple format. With this diversification, you can spread out your risk over a variety of securities.


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This post was updated August 29, 2019. It was originally published September 2, 2019.