What is a Mutual Fund?

Investing is an important part of saving for the future. One of the hardest parts of investing is building a portfolio of stocks and bonds that you’re happy with. Mutual funds are a way to easily invest in pre-built portfolios.

What are Mutual Funds?

Mutual funds are a type of investment that you can use to buy shares in many different securities at once.

To start a mutual fund, the fund’s manager collects money from as many investors as are interested in investing in the fund. Each investor is given shares in the mutual fund based on the amount of money they invest.

The manager uses the pooled money from the fund’s investors to buy different stocks and bonds; which kinds of securities the manager purchases will depend on the mutual fund’s strategy (more on this later).

When an investor wants to invest more in the mutual fund, the manager takes that investor’s money and gives them more shares in the fund. The manager then uses that money to buy more securities for the mutual fund’s portfolio.

When an investor wants to get their money back from a mutual fund, they can sell their shares back to the fund. The manager sells securities as necessary from the fund’s portfolio to return the investor’s money.

Modern mutual funds have millions or billions of dollars in assets under management and hold portfolios that include hundreds of different stocks or bonds. When you buy a share in a mutual fund, you’re effectively buying a small stake in each of the companies and bonds that the mutual fund owns.

This means that you can build a diverse portfolio by buying shares in a single mutual fund.

How Do Mutual Funds Work?

Mutual fund managers build portfolios using the money provided by the mutual fund’s investors. Most mutual funds build their portfolios based on a specific strategy.

Some funds aim to track a specific index of stocks, like the Dow Jones Industrial Average, while others buy and sell shares daily based on the manager’s beliefs about their future price movements.

Unlike stocks, which investors can buy and sell anytime the market is open, investors can only buy and sell shares of mutual funds once each day. After trading closes each day, the mutual fund’s managers will calculate the new per-share price of the mutual fund based on the value of its portfolio and the number of shares that exist in the fund.

Anyone who submitted a sell order since the last calculation of the fund’s value will receive a payment equal to the new per-share price multiplied by the number of shares they sold. Those buying will buy shares at the newly-calculated per-share price.

Investors do not have to buy whole shares in a mutual fund. Instead, investors typically submit buy and sell orders for specific dollar amounts and buy or sell fractional shares in the fund to complete the transaction for the desired amount of money.

For example, someone buying $1,000 worth of a fund with a per-share price of $150 will receive 6.667 shares.

For investors who want to buy and sell shares in a mutual fund during trading hours, exchange-traded funds (ETFs) work quite similarly to mutual funds, but trade on the open market between investors. Similar to mutual funds, ETFs can be purchased through most brokers like E-Trade or Stash.

Mutual Fund Investing Strategies

There is a huge variety of strategies that mutual fund managers use to build their mutual funds’ portfolios.

1. Stock-Focused

A common strategy is to build a mutual fund that focuses on buying shares in different companies. Fund managers can choose the companies to invest in using a number of different criteria.

One common criterion is the company’s market capitalization or total value. Large companies — those worth $10 billion or more — are called large-caps. Small companies worth less than $2 billion are small-caps. Those with market capitalizations between $2 and $10 billion are mid-caps.

In general, small-caps tend to be higher-risk, higher-reward investments while large-caps are more stable, but offer lower potential returns.

Fund managers can also use other strategies, like focusing on stocks from businesses that pay dividends or selecting stocks that are part of a particular index.

2. Bond-Focused

Bond-focused funds invest in different types of bonds. Like stock-focused mutual funds, fund managers can use different strategies when building their funds’ portfolios.

For example, one manager might build a fund that only holds high-quality government debt. Another may focus on municipal bonds, while a third buys lower-grade corporate bonds with higher risks but higher yields.

Investing in a bond fund lets investors get some of the security of bonds while reducing the default risk they could face if they only owned bonds from only one or a few issuers.

3. Balanced

Balanced mutual funds hold a mixture of stocks and bonds. Most aim to give investors a pre-built portfolio to handle all of their investing needs. For example, a balanced fund may aim to hold 70% of its portfolio in American stocks and 30% of its portfolio in American bonds.

This is a common strategy for investors. Stocks tend to offer higher returns, but with more volatility. Bonds are less volatile, but generally have lower returns. Mixing the two lets investors capture some of the higher returns of stocks while using the bonds to reduce volatility.

A common example of this strategy is a target-date mutual fund, which adjusts its allocation to be more conservative — more bonds — as its target date approaches. These types of funds are often used to save for retirement or children’s future college tuition needs. More on these later.

4. Money Market Funds

Money market funds are a special type of mutual fund that holds high quality, short-term debt from companies and governments. These funds function similarly to a savings account or checking account, but don’t come with the same level of insurance and safety.

Still, they are quite low-risk, to the point that many brokerages will hold investors’ uninvested money in a money market fund until the customer decides to withdraw the money or place an order to invest it.

Mutual Fund Management Strategies

Managers can employ a few different strategies when managing their funds’ portfolios.

Passively Managed Funds

The managers of passively managed funds aim to make as few changes to the fund’s portfolio as possible. This reduces the effort required to manage the fund, which lowers its costs. It can also help the fund save on transaction-related costs, such as commissions and taxes.

Instead, the fund’s manager mostly works to make sure the mutual fund’s portfolio reflects its stated goal, rebalancing the portfolio’s holdings as needed and managing the purchase and sale of shares.

A popular strategy for passively managed funds is indexing. Index funds aim to match the performance of a specific index of stocks, such as the S&P 500. The idea is that, while the fund won’t beat the market, it will follow the market closely. If the S&P 500 increases by 10% in a year, the S&P 500 index fund aims to increase by 10% as well.

Proponents of passive investment argue that there are few managers who can consistently beat the market by actively managing a mutual fund’s portfolio — and that even fewer can beat the market by enough to compensate for the added fees related to active management.

Actively Managed Funds

The managers of actively managed funds typically aim to beat the market by buying and selling stocks and bonds based on whether they expect those securities to gain or lose value. Managers look for opportunities to buy when a security is low and to sell when the security is high.

Identifying these opportunities takes a lot of effort, which means these funds tend to charge higher fees than passive funds. It’s also quite difficult to succeed at this endeavor consistently over the long term, so it can be hard to find the mutual funds that will beat the market over long periods of time.

Target-Date Funds

Target-date mutual funds are a special group of mutual funds aimed at people who are saving for retirement.

Typical advice is for people to reduce their stock holdings and increase their bond holdings as they get closer to retirement. Stocks tend to offer higher long-term returns but can be volatile. Bonds are less volatile than stocks but offer lower returns. You want to capture the high returns of stocks when you’re young and avoid high volatility when you’re close to needing the money for retirement.

Target-date funds automatically adjust their portfolios over time, reducing their risk. For example, a target date 2060 fund is designed for people who plan to retire around the year 2060. In 2020, it might hold a 90-10 split of stocks to bonds. By 2030, it might change the mixture to 85-15. By 2060, the mix might be 40-60.

Target-date funds typically publish their expected portfolio breakdowns by year so you can choose the fund that will match your desired portfolio by age.

What Is an Expense Ratio?

Each mutual fund you might consider has something called an expense ratio. Besides the fund’s investment strategy, a mutual fund’s expense ratio is one of the most important factors to consider when deciding whether to invest.

Running a mutual fund requires a lot of work, and the companies that operate mutual funds don’t tend to do that work for free. Instead, they charge a fee to cover the cost of running the fund. That fee is called the expense ratio.

Expense ratios are typically quoted as a percentage. For example, a fund might charge an expense ratio of 0.25%, meaning you’ll pay 0.25% of your assets invested in that fund each year, or $25 for every $10,000 you have invested in the fund.

You don’t have to pay this fee out of pocket. Instead, the fund managers take the fee into account when calculating the mutual fund’s share price at the end of each trading day.

In theory, if you invest $10,000 in a mutual fund with an expense ratio of 0.25% and the securities it holds experience no price changes for a whole year, your position in the fund will be worth $9,975 after one year.

Over the long term, even a small difference in fees can have a huge impact on returns.

Consider two investors. Each puts $10,000 into a mutual fund. One fund charges 0.25% in annual fees and the other charges 0.50%.

Say each fund earns 9% returns, before fees, each year for the next 30 years. After the 30-year period ends, the first investor will have $162,980.58 while the second will have $152,203.13. A difference of just 0.25% in fees cost the second investor more than $10,000 — 6.57% of his portfolio’s final value.

Advantages of Mutual Funds

There are a lot of reasons to invest in mutual funds.

• Easy Diversification. To build a diverse portfolio without mutual funds, you’d need to buy dozens of different stocks and bonds. With a single mutual fund, you can diversify your investment among hundreds of different securities.
• Professional Management. You don’t have to worry about rebalancing your portfolio or buying shares at the right time. The fund’s management team handles those details for you.
• Liquidity. You can buy and sell shares in mutual funds easily in the event that you need to access your funds quickly, making them a liquid investment.
• A Variety of Options. There are thousands of mutual funds out there, each with its own investment strategy. Almost anyone can find a fund that fits their investing needs.
• Low Cost. Many mutual funds charge relatively low fees and have low minimum balance requirements. They’re one of the lowest-cost ways to invest in a large portfolio of securities, especially compared to what you could pay in commissions to build a similar portfolio.

Disadvantages of Mutual Funds

Mutual funds do have some drawbacks you should consider when investing.

• Less Control Over Your Portfolio. If you invest in a mutual fund, you’re relying on the fund manager to construct a portfolio. You can’t decide to invest more in a specific sector or stock unless you buy shares in a fund that focuses on that sector of the market.
• Active Funds Can Be Expensive. While there are many mutual funds with low costs, some, especially actively managed funds, can charge very high fees which can have a major impact on your investment returns.
• Capital Gains. When you sell investments for a profit, you have to pay capital gains taxes. With most investments, you control when you sell them, so you control when you owe the taxes. Mutual funds need to distribute the capital gains they’ve earned regularly, giving you less control over when you pay capital gains taxes. That can make it harder to use tax-minimizing strategies like tax-loss harvesting.
• Cash Drag. Mutual funds need to keep some cash on hand to handle investors selling shares in the fund and to make new investments. This cash doesn’t earn significant returns, which can have a slight impact on your returns compared to investing 100% of your money in the market.

Are Mutual Funds the Right Choice For You?

Mutual funds are a good choice for some investors and a bad choice for others.

The investors who will benefit the most from mutual funds are usually those who want an easy way to build a diverse portfolio. If you’re the type who wants a set-it-and-forget-it solution to investing, a balanced mutual fund with a low expense ratio can be a good way to keep things simple.

People who enjoy managing their own money and who enjoy following the stock market might not get a lot out of mutual funds. One of their primary advantages is convenience, but if you want to manage your own investments, you might be better off buying your own securities.

Final Word

Mutual funds are a powerful tool for investors who want to invest in a diverse portfolio without having to do much investment management themselves.

Many brokerages offer their own mutual funds and often offer reduced fees or commission-free trades for their own funds. If you’re looking to open a brokerage account, it’s worth checking the broker’s fund lineup to see if its funds are a good fit for your investment strategy.