Mutual Funds: Definition, Types And Who Should Invest

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A mutual fund is a type of pooled investment fund in which many people own shares. Mutual funds invest in several different companies, and some even invest in the entire stock market. However, when you buy shares in a mutual fund, you don’t invest in those companies directly. Rather, you own shares in the fund, not in the companies the fund selects.

For example, imagine you invested in a tech-heavy mutual fund. That mutual fund pools money from all its investors and buys shares in a number of tech companies. While the fund likely invests in companies such as Amazon (AMZN) and Microsoft (MSFT), you don’t own shares in those companies. Instead, you simply own shares in the mutual fund.

The fund’s share price fluctuates based on the net asset value (NAV) of all the mutual fund’s holdings. NAV is calculated by dividing the total value of a mutual fund’s assets (less liabilities) by the total number of shares outstanding. So, changes in the fund’s share price reflect the net change in all the companies in which the fund invests.

Mutual funds solve a couple of typical problems for investors:

• Mutual funds allow investors to buy a diversified portfolio without an advisor. Historically, investment advisors have tended to work mainly with those who have large amounts of money, making a well-constructed portfolio less accessible to many investors.
• Mutual funds allow investors to buy an investment portfolio quickly and at low cost, whereas maintaining a portfolio can be unrealistic for most investors to do on their own.

Types of mutual funds

Mutual funds come in a variety of forms, depending on what they invest in and how they aim to meet investors’ various goals. Here are the most common types of mutual funds.

Pros and cons of mutual funds

Mutual funds come with their fair share of benefits and drawbacks. Let’s take a look at both.

Pros

• Mutual funds invest in numerous securities, diversifying your investments and reducing your risk.
• They have low minimum investments compared to personal investment advisors and often no minimum.
• They are managed by professional investors, and the best funds have enviable long-term track records of growing wealth.
• Mutual funds are relatively liquid, and can be redeemed on any day the market is open.
• Index mutual funds are one of the cheapest ways to invest in the market, with very low expense ratios on average.

Cons

• Mutual funds lack complete transparency, meaning you won’t usually know exactly what’s in them (index funds being an exception), so you must rely on the manager’s expertise in picking investments.
• Unlike exchange-traded funds, which can be bought and sold like stocks throughout the trading day, mutual funds can only be exchanged at the end of the day, after the market closes at 4 p.m. Eastern.
• Some mutual funds may also charge commissions — called loads — that can seriously hurt your returns, though it’s easy enough to avoid such fees.
• If the fund has a minimum investment, it’s typically much more than the cost of buying a comparable ETF, where the minimum cost is usually no more than a share.

Mutual fund fees

You’ll want to watch out for the fees mutual funds may charge to avoid having them eat into your investment returns. Just a 1 percent annual fee can cost you tens of thousands of dollars over an investing career and could cause you to fall short of your investment goals.

• 12b-1 fees
  

  You may come across 12b-1 fees, which pay for the costs related to marketing and selling the fund. These fees are captured in a fund’s expense ratio, which shows the annual cost to own the fund as a percentage of your investment. This expense reduces your investment return each year.

• Load
  

  You might also see something called a “load,” which is a commission paid to brokers at the time shares are purchased in the fund. The commission is usually calculated as a percentage of your total investment. Funds that don’t charge this commission are known as “no-load” funds, and there’s little reason for investors to pay this expense, since plenty of great funds don’t charge it.

• Other fees
  

  Mutual funds include information on their fees in the fund’s prospectus, which can be found on the investment manager’s website. It reveals the various operating expenses a fund charges, such as a management fee, which pays for the fund’s manager and investment advisor, as well as legal, accounting and other administrative fees.

Mutual funds vs. ETFs

ETFs often work much like mutual funds, but they have some key differences.

Who should consider investing in mutual funds?

Mutual funds can make sense for many investors at different points in their investing journey. 

• Beginning investors: If you’re just starting out, mutual funds can offer you access to a broadly diversified portfolio for a relatively low cost.
• Advanced investors: If you’re a more experienced investor, you can also benefit from mutual funds’ diversification, while also being able to choose funds that invest in a specific sector that you think is poised for growth. Funds can allow investors to pick industries that could thrive without having to pick individual winners.
• Long-term investors: If you’re investing in funds that own stocks, it’s important to be sure that you have a long time horizon. Stocks are volatile, so you’ll want to be able to hold the investment for at least three years — and five is better — to ride out any volatility and give your investment time to appreciate.

Remember that mutual funds are only as good as the assets the fund invests in. If a fund invests in stocks that perform poorly, the fund will lag right along with them. Make sure you understand how a fund invests before committing any money.

Mutual funds and taxes

Fund managers pass on earnings to investors in the form of distributions, mainly at the end of the year. As the investor, it is your responsibility to report capital gains distributions on your tax return and pay the appropriate taxes. Even if you reinvest your dividends, you are still required to pay taxes on them since they are taxed as income.

If you are responsible for taxes when tax time comes, the fund manager should issue you IRS Form 1099-DIV. One way to reduce your tax liability is to hold mutual funds in a tax-deferred investment vehicle, such as a 401(k) or IRA.

How to buy mutual funds

You can buy shares in a mutual fund from many different brokerages. Employer-sponsored retirement plans such as 401(k) plans invest primarily in mutual funds, so you may already be invested in these funds without even realizing it.

Here are some steps to get started investing with mutual funds:

1. Research mutual funds. Many different types of mutual funds exist, including those with broad exposure (for example, to the whole stock market) and those that cover a narrower niche (such as one industry). So, you’ll want to find funds that suit your strategy.
2. Decide where to buy. The best online brokers offer mutual funds, so you’ll need to decide which one you prefer. Many now offer no-commission trading, but pay attention to the fees for each broker, if any. Calculating your mutual fund fees is also a good idea.
3. Deposit your money and buy. If you’ve already done your research, this is a simple step: just transfer money into your brokerage account and buy the shares you want.
4. Manage your portfolio. Once you’ve bought your shares, there isn’t much work to do with mutual funds. However, periodic rebalancing is a good idea if you have multiple funds.

Bottom line

A mutual fund is a type of investment consisting of stocks, bonds or other securities. The benefits of mutual funds include professional management and built-in diversification. However, mutual fund fees can be high in some cases, though the best mutual funds charge much less.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.