What is a mutual fund?

It’s a managed investment vehicle holding a diverse mix of assets, like stocks and bonds

Author pictureAuthor picture
Author picture
Written by
Author picture
Edited by
two hands full of coins

Diversifying your investments is important. It helps spread your risk across multiple assets and can increase your odds of getting positive returns over time. Mutual funds are a way to get instant diversification, as they let you own a wide range of securities within a single investment vehicle.

But before you invest, it’s important to understand how mutual funds work, the types available, the fees associated with them and how they compare to other investments.


Key insights

  • Mutual funds pool together investor funds to buy individual stocks, bonds or other securities.
  • There are several types of mutual funds, including stock funds, bond funds, balanced funds (hybrid), international funds and more.
  • Mutual funds may have higher fees than passively managed index funds.
  • Mutual funds are managed by a professional team and have a fund manager that decides what goes into the fund.

Mutual fund definition

“A mutual fund is an investment vehicle that invests in stocks, bonds or other securities,” said Carman Kubanda, a financial planner at Innovative Wealth Building.

“When you buy a mutual fund share you are indirectly buying a portion of the underlying investments. This is an easy way to diversify as some mutual funds can hold thousands of different stocks or bonds. Mutual funds have managers who choose the underlying investments, so someone may not want to own one if they want to pick and choose every company they invest in.”

The goal of a mutual fund is to produce gains or income from the investments chosen, as well as manage risk. Mutual funds typically own dozens or hundreds of securities, making them ideal for diversifying your investment holdings within a single fund.

» MORE: What is a good investment?

How does a mutual fund work?

Mutual funds are put together by professional fund managers who choose investments based on the goals of the fund. The fund owns a curated selection of securities, such as stocks, bonds or other investments. Investors earn income from the investments selected, and the fund gains value as the underlying investments grow in value.

When you buy a mutual fund share you are indirectly buying a portion of the underlying investments. This is an easy way to diversify.”
— Carman Kubanda, Innovative Wealth Building

Mutual funds typically aim to outperform an industry benchmark, or index, that their fund is designed to emulate. This means that fund managers buy and sell securities within the fund to try to beat a comparable index that has a similar composition to the mutual fund.

How does a mutual fund make money?

Mutual funds make money from the underlying investments inside the fund. This can come in the form of regular dividends, capital gains or an increase in market price. Mutual fund shareholders get a portion of the money earned within the fund relative to their total ownership percentage of the fund.

Types of mutual funds

There are thousands of mutual funds available on the market. Here are a few of the most popular types:

  • Stock funds consist of a mix of different stocks that fit certain criteria. Stock mutual funds may be defined by the size of the companies they own (market cap), the types of companies they own (growth, blue-chip, dividend-paying) or a blend of several types of stocks.
  • Bond funds own primarily government and corporate bonds and are designed to provide income and more stable returns. Bond funds are considered “safer” than stock funds, though they can go down in value.
  • Balanced funds own a mix of different types of securities across asset classes, such as both stocks and bonds. This creates more diversification within the fund to help offset the risk of asset concentration.
  • Money market funds are low-risk funds that own short-term debt securities, such as U.S. Treasury Bills and other safe investments. These funds are designed to provide risk-free income to investors.
  • Index funds are passively managed funds that mirror a specific market index, such as the S&P 500. These funds offer low expense ratios and are designed to match the performance of their chosen index.
  • International funds own securities outside of the U.S. and may consist of stock, bonds or other investments. These funds are designed to give investors exposure to international markets.
  • Other types of mutual funds include sector funds that focus on a specific market section, or socially responsible investing (SRI) funds that buy stocks of companies that focus on a specific attribute, such as climate change.

How to invest in a mutual fund

To invest in a mutual fund, you can work with a financial advisor or broker that sells you funds, or you can purchase them directly from an investment firm. Purchasing mutual funds directly from a firm typically removes any sales commissions (loads), though you will still pay an annual fund management fee.

You can purchase mutual funds online through most major investment firms, such as Vanguard, Charles Schwab, Fidelity and others. You will need to open an account with them and deposit funds in order to purchase their mutual funds.

There is typically a minimum investment amount required. Once you meet that minimum investment, you can purchase shares of the mutual fund, or even fractional shares, allowing you to invest a specific dollar amount instead of purchasing an exact number of shares.

Mutual fund fees

Mutual funds may have several different fees associated with them.

  • Operating fees, also known as expense ratios, cover the cost of the fund manager and their team, as well as any other expenses associated with operating the fund. This fee is usually charged as a percentage of the overall fund assets under management (AUM). Mutual funds charge an average of 0.66% annually.
  • Shareholder fees are sales fees charged to shareholders when they purchase or sell a mutual fund. Also known as load fees, these charges are paid to brokers as a commission for selling the fund. These fees can range from 1% to 5% (or more), though many mutual funds have shifted to become no-load funds.

» MORE: Invest or pay off debt? Why you should do both

Mutual fund examples

Here are a few different popular mutual funds available today:

  • Vanguard Windsor II Fund (VWNFX) is a value stock fund that focuses on large- and mid-cap companies. This fund is designed for long-term appreciation of undervalued stocks, with lower risk than a growth fund. The expense ratio is 0.34%.
  • Schwab S&P 500 Index Fund (SWPPX) offers a low expense ratio (0.02%) and tracks the S&P 500. It is a market-cap-weighted index fund, meaning the larger the market cap, the more of the company the fund owns, compared to lower market-cap stocks in the fund.
  • DFA US Small Cap Growth Portfolio (DSCGX) aims for long-term capital appreciation by investing in over 500 different small market-cap companies. This fund aims to outperform the Russell 2000 index. The expense ratio is 0.31%.
  • Fidelity Government Money Market Fund (SPAXX) holds U.S. government Treasurys and other government fixed-income securities. It is designed to provide risk-free income to investors. The expense ratio is 0.42%.
  • Dodge & Cox Income Fund (DODIX) is designed to earn a high income and is focused on capital preservation. It owns a variety of corporate bonds and other debt securities. The expense ratio is 0.41%.

Mutual fund vs. index fund

Mutual funds and index funds both pool investors’ money and invest in a diversified selection of securities. In fact, index funds are a type of mutual fund. But not all mutual funds are index funds.

Mutual funds offer a wide range of investment choices and are curated by active fund managers who choose what to put in the fund. Mutual funds can track an industry benchmark and be passively managed, but most are actively managed. Mutual funds usually have higher expense ratios than index funds and may have higher fund turnover as fund managers buy and sell securities within the fund.

Index funds are a type of mutual fund that tracks an industry benchmark, such as the S&P 500. They own the securities that the specified index contains. These funds are passively managed and have very low expense ratios.

Mutual fund

  • Actively managed
  • May have higher fees
  • May incur more taxes due to trading activity and fund structure
  • Wider range of investments chosen by fund managers

Index fund

  • Tax efficient
  • Passively managed
  • Limited investment choices
  • Low fees

Mutual fund vs. ETF

Both mutual funds and exchange-traded funds (ETFs) hold a number of securities within a single fund. And both have fund managers that buy and sell securities within the fund.

Mutual funds are actively managed most of the time and try to beat their respective industry benchmarks. ETFs are usually passively managed and track an index, similar to index funds. But ETFs can be traded during market hours, while mutual funds and index funds cannot.

Mutual fund

  • High minimum investment
  • Fractional shares available
  • Cannot actively trade
  • Capital gains taken from NAV on rebalance

ETF

  • Low minimum investment
  • Only some offer fractional shares
  • Can trade just like a stock
  • No capital gains on fund adjustments
LogoContact
Learn More
LogoContact
Learn More
LogoContact
Learn More

FAQ

What is a mutual fund prospectus?

A mutual fund prospectus offers detailed information about the fund itself, including who the fund managers are, the objectives of the fund, the past performance of the fund and the financial information, including a breakdown of the fees.

What is an expense ratio on a mutual fund?

An expense ratio is the sum of all the fees for a particular mutual fund. This includes both operating and shareholder fees. Expense ratios are expressed as a percentage of the overall fund AUM. These fees are charged on an annual basis.

What’s the average mutual fund return?

Mutual fund returns vary by the type of fund, the amount of time measured and what types of investments are in the fund. Mutual fund returns can be negative or positive, depending on the market in any given year.

On average, mutual funds that track indexes usually provide returns that match that index. For example, an S&P 500 index mutual fund has returned 12.19% annually over the last 10 years (as of September 2023).

Why might a mutual fund be a better investment than individual stocks and bonds?

Mutual funds might be a better investment than individual stocks, bonds or other securities as they give you instant diversification. You can own hundreds, or even thousands, of stocks, bonds or other assets within a single fund. Mutual funds are also professionally managed, making them a hands-off investment.

How are mutual funds taxed?

Mutual funds can be taxed in several ways, depending on your income and how long you held the fund. Buying or selling a mutual fund can result in capital gains or losses, which are taxed at 0%, 15%, 20% or your regular income tax rate.

There are also taxes assessed on dividends paid by the mutual fund. Dividends may be taxed at your income tax rate, or at the capital gains rate if it’s a qualified dividend.

Bottom line

Mutual funds are a popular investment choice for investors who don’t want to build their own portfolio of individual assets and would rather choose a fund that offers instant diversification and risk management.

Actively managed mutual funds can have high fees, though, and typically underperform index mutual funds over long periods. It’s important to research any mutual fund you want to invest in to make sure it fits your risk tolerance, timelines and financial goals.


Article sources
ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
  1. Investment Company Institute, “ Trends in the Expenses and Fees of Funds, 2022 .” Accessed Sept. 24, 2023.
  2. Vanguard, “ VWNFX .” Accessed Sept. 24, 2023.
  3. Schwab, “ Schwab S&P 500 Index Fund .” Accessed Sept. 24, 2023.
  4. Dimensional, “ DSCGX - US Small Cap Growth Portfolio .” Accessed Sept. 24, 2023.
  5. Fidelity, “ Fidelity Government Money Market Fund .” Accessed Sept. 24, 2023.
  6. Dodge & Cox, “ DODIX Income Fund .” Accessed Sept. 24, 2023.
  7. Vanguard, “ VTI - Performance & fees .” Accessed Sept. 24, 2023.
Did you find this article helpful? |
Share this article