What Are Mutual Funds? a Beginner’s Guide to Investing

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• A mutual fund is a portfolio of investments that pools money from investors to purchase multiple securities. 
• Some mutual funds are actively managed with the aim to outperform the market.
• Mutual funds can add value to a portfolio by offering professional management and diversification.

A mutual fund is a type of investment vehicle that pools money from many investors to purchase stocks, bonds, or other securities. Investors who mutually contribute to the fund company become part owners of the fund’s portfolio and the investment gains or losses it generates. 

Typically, mutual funds provide broad access to a diversified pool of investments for relatively small upfront amounts, and they can give investors access to professional investment management.

“Mutual funds are an easy and well-established way to give everyday investors diversification,” says Michael Iachini, CFP and head of manager research for Charles Schwab Investment Advisory. “They are well established since the 1920s, and they have a track record of working for investors.”

You can invest in mutual funds through a broker or investment platform. The best online brokerages offer low minimums, account flexibility, investment tools and resources, and access to human advisors for personalized guidance and advice.

Here’s what to know about mutual funds, including how they work, what to watch out for, and how to get started investing in them. 

How mutual funds work

Mutual funds are regulated investment vehicles that pool investors’ money to purchase a basket of underlying securities. So rather than purchasing one stock, for example, you might invest in a mutual fund that gives you access to hundreds of stocks. Everything is proportional, though, so if you invest $10,000 in a mutual fund whose holdings go up by 10%, you’d gain $1,000, aside from any taxes and fees.

More specifically, the main components of how mutual funds work include the following:

Pooling of money

When you invest in a mutual fund, you’re buying shares of the mutual fund, not the underlying securities that the mutual fund holds. Still, mutual funds pool together investors’ money to buy securities like stocks or bonds, depending on the mutual fund’s investment strategy. Most mutual funds are open-ended, meaning that shares of the fund can continually be created or destroyed, depending on whether investors are putting money in or pulling money out.

Professional management

Generally, mutual funds are professionally managed, either by an individual portfolio manager or a team of investment professionals, who set the fund’s investment strategy and manage the buying and selling of securities. When you buy a mutual fund, you’re purchasing partial ownership of the fund, which gives you a proportional stake in its entire investment portfolio.

Some mutual funds are actively managed, meaning the professional managers decide what to invest in and when to buy and sell securities to try to maximize returns and minimize losses. Others are passively managed, which still involves the work of a professional handling the investments, but they simply try to match the holdings and return of an index, such as the S&P 500.

This differs from buying an individual stock, where you buy partial ownership directly in a company and manage any subsequent moves yourself (unless you have a financial manager). 

Net asset value (NAV)

The price of a mutual fund is determined by its net asset value (NAV), which takes all of the portfolio’s securities into account. It is found by dividing the total value of the fund’s assets (cash and securities) by the number of outstanding shares of the fund. 

Since a mutual fund’s portfolio consists of many securities that change price throughout the day, the NAV is calculated at the end of the market day. Because of this, mutual funds trade only once per day, after the stock market closes.

Example: Let’s say you want to put $2,000 toward a mutual fund. If the fund’s NAV is $20, you’re able to purchase 100 shares — not counting fees. Along with other investors’ contributions, that $2,000 would then be used by the fund manager to make trades. 

Types of mutual funds

Mutual funds aren’t homogenous. They are classified into many different types, based on factors such as the securities they invest in and the investment goals they seek to achieve. Here are some of the major types of mutual fund categories:

Equity funds

Equity funds invest mostly in stocks and are often categorized by factors like investment style and market capitalization. For example, a large-cap growth equity fund invests in large companies that are expected to have above-average growth in revenue and profit (although that doesn’t always translate into higher investment returns, as the asset prices can reflect these growth expectations).

“Remember there are more than 10,000 equity mutual funds, yet there are only 2,800 stocks that trade on the New York Stock Exchange,” says Clark Kendall, president and CEO of Kendall Capital. “Equity mutual funds do a great job of slicing and dicing the equity markets however you would like to have your market served to you.”

Quick tip: Over the long term, equity funds can often generate much higher returns than many other mutual funds such as bond funds. Though stock investments can be volatile, equity funds offer more portfolio diversity than individual stock investments, which can help reduce risk and improve returns.

Growth funds

As mentioned, equity funds are often divided by investment style, with growth funds typically applying to mutual funds that invest in growth stocks. The goal of growth funds is typically to beat the market through capital/price appreciation, as opposed to receiving significant dividend income.  

Value funds

In contrast to growth funds, value funds invest in stocks that are considered to be undervalued in price based on underlying financial fundamentals. Value stocks also are often well-established companies that pay dividends. However, just because some investors consider them to be undervalued does not mean they will end up outperforming the market.

Blend funds

Blend funds combine different investment strategies, like investing in a mix of growth and value stocks, or large-cap and small-cap companies.

Index funds

Index funds are passively managed, meaning the mutual fund’s goal is to simply track a specific market index, not beat it. For example, an S&P 500 index fund generally holds the same securities as the S&P 500 in an equivalent proportion to the index’s weighting, or at least replicates that exposure through sampling. If the S&P 500 removes a company from its index and replaces it with another company, the index fund would generally do the same. These funds tend to have much lower fees than actively managed funds and often end up outperforming active funds net of fees.

Bond funds

Mutual funds don’t have to just invest in stocks. Bond funds are mutual funds that invest in various types of bonds, and these are often split into different categories similar to how equity funds are split by investment style. For example, there are corporate bond funds, government bond funds, and municipal bond funds. And these are often further divided based on the duration of the underlying bonds and other factors like the credit rating of the bonds.

Balanced funds

Mutual funds don’t have to stick to one type of asset either. Balanced funds invest in a balanced mix of assets, typically split between stocks and bonds.

Hybrid funds

Hybrid funds are similar to balanced funds in that they invest in two or more asset classes, but they are typically tilted toward one type of asset over another, and they may take on more risk than balanced funds. Hybrid funds often combine stocks and bonds, but may even include other assets, such as commodities like raw materials or precious metals.

While some hybrid funds may carry more risk than balanced funds, they might be used to further diversify an investor’s portfolio and can offer an investor a potential combination of income generation and capital appreciation.

Money market funds

Money market funds are fixed-income mutual funds that invest in short-term debt securities with low credit risk. These funds aim to provide liquidity, maintain a stable NAV, and distribute regular income earned on its securities to its investors. 

Money market funds are categorized as government, prime, or tax-exempt, depending on the securities held within the fund. Securities often invested in money market funds include short-term U.S. Treasury securities, federal agency notes, certificates of deposit, corporate commercial paper, and municipal agency obligations. 

Quick tip: Money market funds are often used similar to savings accounts, such as if you’re parking money in a brokerage account before deciding what other funds to invest in. That’s because these funds often lag the performance of other mutual funds, so they’re typically not used for long-term growth, but they can offer more stability and liquidity than many other funds.

Specialty funds

Specialty funds, or sector funds, concentrate on particular types of securities, like those within a specific industry or market sector, such as real estate, technology, or healthcare. Examples of specialty funds include real estate mutual funds, which invest in REITs and other real estate-related investments. Because specialty funds are often focused on specific sectors like health care and technology, they aren’t always as diverse as other equity funds, so you’ll likely want to mix these in with other types of funds and assets. 

Also, some specialty mutual funds invest in categories of assets like those with strong environmental, social, and governance (ESG) scores. These funds cater to investors who are increasingly looking to direct their money to companies that are making positive social or environmental impacts in the world. 

Target-date funds

Target-date funds operate with a specific retirement goal date in mind. For example, a 2065 target-date fund is geared toward those who are in their mid-30s and plan to retire around the year 2065. 

These funds typically invest in a basket of other mutual funds, so they’re also known as a type of “fund of funds.” Target-date funds automatically rebalance the asset mix within their portfolio over time and become more risk-averse as the target date nears. Target-date funds are popular within retirement savings accounts like 401(k)s, as they make it easy for individuals to plan for retirement, although the fees are typically a little higher than if you were to directly invest in the underlying mutual funds.

Advantages of mutual funds

Mutual funds tend to offer several benefits to investors, such as: 

Diversification

Through one investment, you can access a broad base of underlying investments. This can help reduce risk and volatility and often leads to better returns than non-diversified investments.

Professional management

Investing in a mutual fund is somewhat like hiring a professional investment manager. Even if you’re investing in an index fund, you get the benefit of the professional manager trying to match the index for you, rather than you having to replicate the index by trading individual stocks.

Liquidity

Although mutual funds aren’t quite as liquid as some other investments like exchange-traded funds (ETFs), it’s still generally easy and fast to buy and sell shares. Trading happens once per day, but you can generally get your money in and out of a fund within a few business days, depending on factors like which brokerage you use.

Accessibility

Here too, mutual funds aren’t quite as accessible as ETFs, but they’re generally still broadly accessible. For example, some mutual fund managers have no investment minimums, and others often have low enough minimums of a few thousand dollars that many investors can still access these funds, without having to be a high-net-worth investor. It can also be more accessible to buy into one mutual fund than trying to purchase all of the underlying securities a fund holds.

Convenience

Mutual funds also tend to be convenient. Not only does the fund manager handle the investment strategy for you, but mutual funds also often stand out from ETFs in terms of convenience, such as by making it easy to set up automatic investment plans that allow for the purchasing of fractional shares.

Disadvantages of mutual funds

Although mutual funds offer a lot of possible advantages, there are some downsides to watch out for, such as:

Fees and expenses

Mutual funds carry annual fees, known as expense ratios, that can eat into returns. These are expressed as a percentage, e.g., a 1% expense ratio means you pay 1% of the invested amount in fees per year. That might not sound like much at first, but it adds up over time. 

Mutual funds can also have other fees like load fees, which are essentially upfront sales charges when you purchase shares. Mutual funds are often divided into different share classes based on investment minimums, with different fees per share class. Typically, the higher the initial investment, the lower the fees.

You can find all associated fees outlined in detail in the mutual fund’s prospectus.

Investment minimums

Many mutual funds have investment minimums, and while these are often still accessible for individuals, the minimums can be several thousands of dollars. So, you might not be able to invest in many different mutual funds if the investment minimums are prohibitively high.

Lack of control

The flip side of professional management is that you lack control over the underlying investments. You can choose the fund you’d like, but you don’t get to decide when the manager buys or sells securities, and the fund might invest in companies you don’t want to own.

Tax inefficiency

Mutual funds are generally considered to be less tax-efficient than ETFs, so if you’re holding mutual funds in a taxable account, you may want to take this into account. Specifically, mutual funds can trigger capital gains taxes based on the gains and losses of the fund overall, not just your own investments. So, perhaps you bought into the fund late in the year and have yet to realize a gain, but because the mutual fund made trades earlier in the year that triggered capital gains, you could still owe taxes for what the fund gained.

How to choose mutual funds

There are many types of mutual funds to choose from, and within those categories, there can be hundreds or thousands of options. To choose the right ones, consider factors such as:

Investment goals/risk tolerance

Mutual funds have varying investment goals. For example, some might aim for high dividend payouts and low volatility, while others might take on more risk for more potential capital appreciation. Consider your goals and risk tolerance and see how those align with a fund’s investment objectives/strategy.

Fees and expenses

Make sure you understand the full fees and expenses of a mutual fund before investing and compare the costs of different funds to help inform your decision. Also, the investment minimums might dictate which funds you can and can’t invest in.

Past performance

Although past performance doesn’t guarantee future results, you might review a fund’s track record to at least get a sense of what you might expect in the future. For example, a fund with a long history of underperforming the index or competitors might not be your preferred choice, unless you have confidence that they have a strategy in place going forward that will lead to better results.

Rating/reviews

Many mutual funds are rated or reviewed by services such as Morningstar, which can help you decide which funds seem to be well-managed and seem to be a good fit. You can also research the fund manager’s track record and experience to come up with your own assessment.

FAQs about mutual funds