Table of Contents
Mutual funds pool money from multiple investors to purchase a collection of securities, such as stocks and bonds. They offer a way to hold a range of investments through a single fund, which can make building a diversified portfolio simpler. Mutual funds are overseen by professional investment firms. They can be actively managed by a portfolio team seeking to outperform a market benchmark, or passively managed as index funds that automatically track a specific market index to replicate its performance.
Mutual funds share some similarities with exchange-traded funds (ETFs), but the two have important differences in how they trade and how they’re priced. Understanding how mutual funds work, the types available, and their potential risks and benefits can help you decide whether they’re a good fit for your financial goals.
Key Points
• Mutual funds pool money from multiple investors to buy a collection of securities like stocks and bonds.
• Funds can be actively managed by investment professionals or passively managed to track a market index.
• Mutual funds are priced once per day at their net asset value (NAV) after the markets close.
• Common expenses include expense ratios, sales loads, and transaction fees, which can impact potential returns.
• Unlike ETFs, mutual funds do not trade continuously on exchanges during market hours.
What Are Mutual Funds? Definition & Meaning
A mutual fund gives you a way to own a share of a portfolio containing multiple assets, such as stocks, bonds, and other securities. Rather than choosing and purchasing each security individually, you buy shares of the fund and gain exposure to the investments it holds.
This structure can make it easier to diversify your portfolio without having to research and select each holding yourself. While diversification can help reduce the impact of a poor-performing investment, it doesn’t eliminate risk. For example, a mutual fund that holds stocks across the S&P 500 may be less affected by one company’s decline than a portfolio consisting only of that company’s stock. However, the fund can still lose value if the broader market falls. Also keep in mind that not all mutual funds are broadly diversified; some may be heavily concentrated in a single sector (like technology or healthcare).
How Mutual Funds Work & Generate Returns
A mutual fund typically operates as an investment company that pools shareholders’ money and invests it according to a stated objective or strategy. A fund may focus on a particular asset class, market index, industry, or investment goal.
Mutual funds can be actively or passively managed.
• Actively managed funds: These funds have a portfolio manager or management team that selects investments in an effort to outperform a benchmark or meet another stated objective. This approach involves making decisions about which securities to buy, hold, or sell, and it often comes with higher fees than passive management.
• Passively managed funds: These funds aim to track the performance of a market index, such as the Russell 2000, which represents a segment of smaller U.S. companies. The fund holds securities in an effort to match the index’s performance, often buying or selling holdings when the index changes. These funds generally seek to replicate an index rather than outperform it.
Mutual funds can potentially generate returns in several ways. Their holdings may increase in price, bonds may pay interest, and stocks may pay dividends. Depending on the fund, investors may receive distributions from income or capital gains. Investors may also benefit if the fund’s share price increases. However, returns aren’t guaranteed and losses are possible.
Types of Mutual Funds
There are many varieties of mutual funds, with different investment objectives, holdings, risk levels, and management strategies.
Common Mutual Fund Categories
Mutual funds can be classified by the assets they hold, the markets or industries they focus on, or the goals they’re designed to support. Some funds fit into more than one category. For example, a target-date fund may hold both stocks and bonds, while a sector fund may focus on a particular part of the stock market.
Funds by Asset Class
Some mutual funds focus primarily on a particular asset class, or group of investments with similar characteristics. Common examples include:
• Equity funds: These funds invest primarily in stocks. Some focus on large or small companies, growth stocks, or particular investment styles.
• Bond funds: These funds invest primarily in bonds and other debt securities. Their risks can vary based on interest rates, credit quality, and the types of bonds they hold.
• Money market funds: Money market funds invest in short-term, generally high-quality debt securities. They typically aim for stability and liquidity, but they are not the same as FDIC-insured bank deposits.
• Balanced funds: These funds typically invest in a fairly even split of equity and fixed income securities with the goal of seeking income while preserving capital.
Sector or Industry Funds
Sector and industry funds concentrate on companies in a particular part of the economy. A sector is a broad category, while an industry is a more specific grouping within it. For example, the energy sector includes industries related to oil and gas, as well as renewable energy.
These funds can provide targeted exposure to a particular area of the market, but their concentration can also increase risk. If the sector or industry struggles, the fund may be affected more significantly than a broadly diversified fund.
Target-Date Funds
Target-date funds hold a mix of asset classes, usually stocks and bonds, and are designed around a particular year when an investor expects to retire or reach another financial goal.
The fund typically adjusts its asset allocation over time, gradually shifting toward a more conservative mix as the target date approaches. This process is intended to reduce risk as the goal gets closer, although it doesn’t eliminate the possibility of losses.
Target-date funds are often available through employer-sponsored retirement plans, such as 401(k)s. They can simplify retirement saving by combining multiple asset classes and adjusting the mix over time. However, funds with the same target year can have different strategies, fees, and risk levels.
The Financial Mechanics of Mutual Funds
Understanding how mutual funds price their shares and charge fees can help you compare options and evaluate their costs.
The Pricing Puzzle: Net Asset Value Explained
Mutual funds calculate their net asset value (NAV) to determine the per-share value of the fund’s holdings. NAV is calculated by subtracting the fund’s liabilities from the total value of its assets and dividing the result by the number of outstanding shares.
For example, if a fund has $100 million in assets, $5 million in liabilities, and 10 million outstanding shares, its NAV would be $9.50 per share.
Mutual funds typically calculate NAV once each business day, typically after the major U.S. stock markets close. When you buy or redeem shares of a traditional mutual fund, your transaction generally receives the next NAV calculated after the fund receives your order.
The NAV reflects the underlying value of the fund’s assets minus its operational expenses, but it does not account for individual sales charges or transaction-related fees that an investor might incur.
Fee Structures: Costs Associated with Mutual Fund Investing
Mutual funds typically charge expenses to cover costs such as portfolio management, administration, recordkeeping, and other operations. These expenses can vary significantly between funds and affect potential returns over time.
One key cost is the expense ratio, which represents a fund’s annual operating expenses as a percentage of its assets. For example, a fund with a 0.50% expense ratio charges approximately $5 per year for every $1,000 invested, based on the average amount invested. The actual dollar cost can change as the account balance changes.
Actively managed funds often have higher expense ratios than comparable passive funds because they may require more research and portfolio management.
Other possible costs include:
• Sales loads: Some mutual funds charge a sales fee when you buy or sell shares.
• Transaction fees: A brokerage may charge a fee to purchase or sell certain mutual funds.
• Other account or service fees: Depending on the provider, additional charges may apply.
Investors generally don’t receive a separate bill for a fund’s operating expenses, such as the expense ratio; instead, those costs are deducted directly from the fund’s assets and are reflected in its performance. However, other costs — such as sales loads, transaction fees, and account service fees — are typically charged separately. Reviewing a fund’s prospectus and fee disclosures can help you understand the costs before buying shares.
The Pros and Cons of Investing in Mutual Funds
Mutual funds offer a convenient way to get exposure to a wide variety of investments, but they aren’t without their drawbacks. Whether they’re a good fit for you depends on the fund’s strategy, overall costs, associated risks, and your personal financial situation.
Potential Benefits of Diversification and Professional Management
Mutual funds offer several potential advantages:
• Diversification: A fund can hold many securities, reducing reliance on any single holding. The degree of diversification depends on the fund’s strategy.
• Convenience: Buying one fund can provide exposure to a broad collection of securities without requiring you to purchase each one individually.
• Professional management: Actively managed funds have professionals making portfolio decisions, while passive funds follow a defined index-tracking strategy.
• Choice: There are funds for different asset classes, market segments, investment objectives, and time horizons.
These features may appeal to people who prefer a simpler way to manage a portfolio. However, professional management doesn’t guarantee better results, and not every mutual fund is broadly diversified.
Considering the Risks: No Guarantees and Potential for High Costs
Mutual funds carry risks, and you can lose money if the value of their holdings declines. The level of risk depends on the fund’s investments and strategy. For example, a fund that concentrates on one industry may be more vulnerable to a downturn in that industry than a fund that holds a broad range of securities. Diversification can help spread risk, but it can’t prevent losses if many of a funds’ holdings decline in value
Costs are another consideration. Some mutual funds charge sales loads or other fees in addition to their ongoing operating expenses. These costs can reduce your potential returns over time. Actively managed funds may also underperform their benchmarks despite the fees paid for professional management.
Taxes and Cash Drag in Mutual Funds
Taxes are another factor to consider, particularly in taxable brokerage accounts. Mutual funds may distribute dividends, interest income, and capital gains to shareholders. According to the IRS, these distributions may be taxable in the year they’re received, even if an investor automatically reinvests them rather than taking them in cash. The tax treatment depends on the type of distribution, the account, and the investor’s circumstances.
Cash drag is a separate consideration. This can occur when a fund maintains a portion of its portfolio in cash or cash equivalents that yield lower returns than its core investments during a market upswing. Consequently, this cash cushion can act as a drag, reducing the fund’s overall performance relative to a fully invested portfolio. However, these cash holdings are often intentional and needed by managers to pay out withdrawing investors and run the fund daily.
Mutual Fund Investments and You
Whether a mutual fund fits your financial goals depends on a number of factors, including your time horizon, risk tolerance, and the role you want the fund to play in your portfolio. Comparing a fund’s holdings, goals, costs, and risks can help you assess whether it may be a good fit for you.
Are Mutual Funds Right for Your Portfolio?
Mutual funds can be worth considering for people who want access to a collection of securities through a single product. They can be useful for beginners, but they aren’t limited to new investors.
A broad-market mutual fund may provide exposure to many companies, while a specialized fund may focus on a narrower group of assets. Some funds are designed for long-term goals, such as retirement, while others focus on shorter-term or more specific objectives.
Before choosing a fund, it’s a good idea to consider what it holds, how it’s managed, how much it costs, and how its risks compare with your financial goals. It’s also important to look at your overall portfolio, since owning multiple funds doesn’t necessarily mean you’re well diversified if they hold many of the same securities.
Can You Cash Out Anytime? Understanding Liquidity
Mutual funds are generally considered liquid because investors can usually redeem their shares on business days. However, traditional mutual funds don’t trade continuously throughout the day like stocks or ETFs.
When you submit an order to sell mutual fund shares, the transaction generally occurs at the next calculated NAV, provided the order meets the fund’s cutoff time. You won’t know the final execution price when you submit an order during the trading day.
It generally takes one business day for a trade to officially settle and for the cash to reach your brokerage account. Transferring it to your checking or savings account can add one to three days to the timeline. Keep in mind that selling mutual fund shares can trigger several immediate costs and tax liabilities depending on the type of mutual fund and how long you’ve held it.
Mutual Funds vs ETFs: Key Differences
Mutual funds and exchange-traded funds (ETFs) both pool money to hold a collection of assets. Whether you buy shares of a mutual fund or invest in ETFs, your single purchase gives you fractional ownership of a defined basket of underlying securities. However, these funds differ in how investors buy and sell shares, how prices are determined, and how costs are structured.
Tax efficiency can also differ. ETFs are generally considered more tax efficient than mutual funds because their structure can help limit capital gains distributions. However, both fund types may trigger capital gains taxes, depending on how they’re held and when shares are sold.
Mutual Funds vs ETFs: A Comparative Analysis
Both mutual funds and ETFs are widely used, and each has features that may suit different needs and goals.
| Feature | Mutual Funds | ETFs |
|---|---|---|
| How they trade | Investors buy and sell through the fund, typically using a brokerage or retirement plan. | Investors generally buy and sell shares on an exchange through a brokerage. |
| Pricing | Shares are generally priced once per business day at NAV. | Shares trade throughout the day at market prices, which change throughout the day. |
| Trading flexibility | Orders generally execute at the next calculated NAV after receipt. | Investors can generally trade any time during market hours. |
| Costs | May have expense ratios, sales loads, transaction fees, or other charges. | May have expense ratios, brokerage commissions, bid-ask spreads, or other trading costs. |
| Management | Can be actively or passively managed but are more frequently actively managed. | Can be actively or passively managed, but are more frequently passively managed. |
| Minimum purchase | Some funds have minimum initial investments based on a specific dollar amount. | Often purchased at the price of one share, with fractional shares available through some brokerages. |
Recommended: ETFs vs. Index Funds
Understanding Fund Classes and What They Mean for Your Investment
Some mutual funds offer multiple share classes. These classes generally hold the same underlying portfolio but have different fee structures, sales charges, or eligibility requirements. The differences can affect how much investors pay over time.
For example:
• Class A shares: The most common option, these shares typically charge an upfront sales load but offer lower ongoing operating expenses relative to other classes.
• Class B shares: This class historically charged a back-end sales load that gradually declined over time. However, this share class has become increasingly rare in the market.
• Class C shares: This class generally bypasses upfront charges but often applies a fee if shares are sold within a short window, typically one year. They also tend to carry higher ongoing expenses than Class A shares.
These labels aren’t universal, and not every mutual fund offers all three classes. Some funds offer other share classes with different pricing arrangements, including institutional shares that may have eligibility requirements.
When comparing share classes, it’s a good idea to look at the total costs over the period you expect to hold the fund, including upfront and back-end sales loads and ongoing expenses. The lowest upfront cost doesn’t always mean the lowest total cost.
Getting Started with Mutual Funds
If you decide to explore mutual funds, these steps can help you narrow your choices and understand what you’re buying before you invest.
Steps to Your First Mutual Fund Investment
• Identify your goals and timeframe: Consider what you’re saving for and when you’ll need the money. Your specific goals and time horizon can help determine which types of funds and levels of risk may be appropriate.
• Research and compare mutual funds. Compare funds based on their investment objectives, holdings, management approach, risks, and costs. Review the prospectus and fee disclosures to understand the fund’s strategy, expense ratio, sales charges, and other potential fees.
• Consider how the fund fits your portfolio. Look at how a fund’s holdings overlap with other investments you own and whether it provides the mix of assets you want. Owning multiple funds doesn’t necessarily mean you’re well diversified if they hold many of the same securities.
• Choose an account or brokerage. You may be able to purchase mutual funds through a traditional brokerage account, an online trading platform, an individual retirement account (IRA), or an employer-sponsored retirement plan such as a 401(k). Available funds and fees can vary by provider and account type.
• Buy shares and monitor your portfolio. Once you’ve chosen a fund, follow your platform’s process to place an order. Review your portfolio periodically to see whether it remains aligned with your goals and consider rebalancing if your asset location changes.
Working With Financial Advisors: Finding Guidance in Mutual Fund Investing
A financial professional may be able to help you compare mutual funds, understand their risks and fees, and determine how they might fit into your overall financial plan.
Before working with an adviser, it’s important to ask about their qualifications, how they’re compensated, and whether they receive commissions or other payments related to the funds they recommend. Understanding these details can help you evaluate potential conflicts of interest and the total cost of getting advice.
The Takeaway
Mutual funds pool money from multiple investors to purchase a collection of securities, allowing people to access a range of investments through a single fund. They can offer diversification, convenience, and, in some cases, professional management. However, funds vary in their holdings, risk levels, fees, and objectives, and diversification doesn’t eliminate the possibility of losses.
Before choosing a mutual fund, you’ll want to compare its strategy, costs, and risks with your financial goals. Understanding how mutual funds work can help you decide whether they belong in your portfolio and how they compare with alternatives such as ETFs.
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FAQ
What is the difference between load and no-load mutual funds?
Load mutual funds charge a sales fee when you buy or sell shares, depending on the fund’s fee structure. A front-end loan is charged when you buy shares, while a back-end load may apply when you sell them. No-load mutual funds don’t charge these sales loans, but they may still have expense ratios, transaction fees, or other costs.
How are capital gains on mutual funds taxed?
In taxable accounts, mutual fund capital gains distributions are generally taxable in the year they’re received, even if you reinvest them. Short-term capital gains distributions are generally taxed as ordinary income, while long-term capital gains distributions typically qualify for long-term capital gains tax rates. You may also owe capital gains tax when you sell fund shares for more than your adjusted cost basis. Tax rules vary by account type and individual circumstances, so it’s wise to consult a tax professional.
What is the minimum investment required for a mutual fund?
Minimum investments vary by fund and brokerage. Some mutual funds require an initial investment of $1,000 or more, while others have no minimum or allow you to start with a relatively small amount. Employer-sponsored retirement plans may also offer mutual funds through payroll contributions. It’s important to check the fund’s minimum requirements and your brokerage’s policies before buying shares.
How do index mutual funds differ from actively managed mutual funds?
Index mutual funds aim to track a specific market index, such as the S&P 500, by holding securities that represent the index. Actively managed mutual funds have managers who select investments in an attempt to outperform a benchmark or meet another objective. Index funds generally have lower expenses because they require less hands-on management, although costs vary. Neither approach guarantees positive returns or better performance.
How do mutual fund dividend reinvestment plans work?
A mutual fund’s dividend reinvestment plan automatically uses eligible dividend distributions to purchase additional fund shares rather than paying the money to you in cash. Reinvesting can increase the number of shares you hold over time. Depending on the fund, reinvestment may occur automatically or require you to select that option through your brokerage. In a taxable account, reinvested dividends may still be taxable in the year they’re distributed.
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Mutual Funds (MFs): Investors should read and carefully consider the information contained in the prospectus, which contains the Mutual Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or SoFi's customer service at: 1.855.456.7634. Mutual Funds must be bought and sold at NAV (Net Asset Value); unless otherwise noted in the prospectus, trades are only done once per day after the markets close. Investment returns are subject to risks. Shares may be worth more or less their original value when redeemed. The diversification of a mutual fund will not protect against loss. A mutual fund may not achieve its stated investment objective. Rebalancing and other activities within the fund may have tax implications.
Investment Risk: Diversification can help reduce some investment risk, but cannot guarantee profit nor fully protect in a down market.
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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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