Mutual Funds: What They Are and How Do They Work
Mutual funds are an investment product that makes it simple to invest in diversified assets. Be sure to keep an eye on fees, however.
April 20, 2022
This article is provided for informational purposes only and should not be construed as legal or investment advice. Always consult with a professional financial or investment advisor before making investment decisions.
Investing can feel intimidating. There are dozens of potential asset classes to invest in, thousands of companies to buy stock in, and a lot of buzzwords that can feel confusing for beginners.
Many investors choose a hands-off approach and focus on investing in mutual funds. But what are mutual funds, exactly — and what do investors need to know about them?
What are mutual funds?
Mutual funds are a type of investment product that are available to everyday investors.
Mutual funds pool money from many different investors to buy a basket of assets — usually stocks or bonds, or a mix of both.
Professional money managers then manage the mutual fund, buying and selling assets to earn returns.
To better understand, let’s look at an example.
Mutual fund “ABC” is set up to invest in technology growth stocks.
It is managed by a team of professional money managers.
The ABC fund raises $100 million from thousands of different investors (some large, some small).
That $100 million is used to invest in dozens of different companies that the fund managers believe will perform well.
The investors in ABC fund now collectively own all the underlying assets that the fund managers have purchased.
Investors can buy and sell shares in the ABC fund on the stock market.
If demand for the fund is strong, more money will flow into the fund and the managers will buy more of the underlying assets.
One of the key advantages of mutual funds is that they provide everyday investors with access to professionally managed funds. Theoretically, these funds can earn strong returns.
Mutual funds charge fees to manage the money. Expense ratios (annual fees) are usually in the 0.5% to 2% range. There may be upfront fees (called “load” fees), as well.
Mutual funds are somewhat similar to exchange-traded funds (ETFs). When comparing ETF vs. mutual funds, there are a few key differences:
Most mutual funds are actively managed, while most ETFs are passively managed.
Mutual funds only trade once per day (at the close of the market), while ETFs trade instantly like stocks.
Mutual funds tend to have higher fees than ETFs.
In addition to the ETF vs. mutual fund debate, we can also compare mutual funds to other investment classes.
Mutual funds compared to other investments
Mutual funds are just one of many different investment products available. Here’s an overview.
Individual stocks vs mutual funds
Investors can buy individual stocks — Microsoft or Coca-Cola, for example. Or, they can buy a mutual fund and trust in the money managers’ stock selections. Mutual funds typically buy dozens or even hundreds of different stocks.
ETF vs. mutual fund
Exchange-traded funds (ETFs) often offer a similar benefit to investors: They hold dozens, hundreds or even thousands of stocks. ETFs trade instantly, just like a stock, while mutual funds only trade once per trading day. ETFs typically also have lower fees.
Index fund vs. mutual fund
Index funds are designed to track the performance of an underlying stock market index. An S&P 500 index fund, for example, will invest in all 500 of the companies included in the S&P 500 index. Index funds are usually structured as ETFs, but can also be technically structured as mutual funds.
Popular mutual funds
There are two types of mutual funds: Passively managed and actively managed. Passive funds are “buy and hold” and often track the performance of an index. Active funds use active trading strategies to attempt to maximize returns.
Here’s a look at some of the most popular mutual funds. You can look at the largest mutual funds by size (which are almost all passive funds), or sort by highest average mutual fund return (which are sometimes active funds).
Passive mutual funds
Vanguard Total Stock Market Index Fund(VTSAX) - a passively managed index fund mutual fund that tracks the total US stock market.
Vanguard 500 Index Fund(VFIAX) - a passive mutual fund that tracks the S&P 500 index.
Fidelity Government Money Market Fund(SPAXX) - a money market mutual fund holding treasury bills, government repurchase agreements and cash equivalents.
Vanguard Total Bond Market Index Fund(VBTLX) - a passively managed mutual fund that tracks the total US bond market.
See the largest mutual funds by holdings here.
Active mutual funds
American Funds The Growth Fund of America Class (AGTHX) - an active mutual fund that focuses on large-cap growth stocks and cyclical opportunities.
Fidelity Contrafund(FCNTX) - an actual mutual fund that focuses on large-cap growth stocks.
T. Rowe Price Blue Chip Growth Fund (TRBCX) - an active mutual fund focusing on high-quality “blue chip” growth stocks.
See the largest active mutual funds by holdings here.
Pros and cons of mutual funds
There are both advantages and disadvantages to consider when it comes to mutual funds and when considering the ETF vs. mutual fund decision.
Pros
Professionally managed: Mutual funds are managed by teams of finance professionals, which means your money is in experienced hands.
High return potential: Many mutual funds actively trade assets to try to earn higher returns. This means that they have the potential to earn very high returns (but they could also earn less than the market or lose money).
Easy diversification: Diversification (spreading out your bets) is a key component of investing success. Most mutual funds hold hundreds of assets, which can add powerful diversification to your portfolio.
Cons
High fees: Mutual funds often charge high investment fees, which can reduce your long-term returns. The expense ratio is the biggest fee to look out for, which can range from 0.1% to 2% or more per year.
Tax inefficiency: If you hold mutual funds in a taxable (non-retirement) account, you may end up paying more in capital gains taxes than you expect. When the fund manager sells an asset, that can create a distribution for fundholders — which creates a taxable event.
May underperform the market: Most mutual funds attempt to outperform the overall stock market — and many fail to do so. In fact, data from the University of Chicago shows that 74% of active equity mutual funds underperform the S&P 500 index.
Learn more about investing
Ready to learn more about the world of finance and investing? These helpful resources are a great place to start:
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