Mutual Funds: What They Are & How They Work
In a word, mutual funds allow investors to own shares of companies or bond issues, but on a lower scale of risk. With a history of reliable returns and broad access to the market, mutual funds are still very much in demand and should continue to be so going forward.
What Are Mutual Funds?
A mutual fund is a financial vehicle managed by investment companies that pool cash from a variety of investors and invests that money for them. Mutual funds are available in a broad number of asset classes but are most commonly used as stock, bond, commodity, and short-term debt funds.
Americans love their mutual funds, with total fund assets standing at $24 trillion in March, 2022, according to Statista.
Mutual funds are managed by professional portfolio managers, who manage the funds on a daily basis, adhering to the goals and objectives laid out in the fund prospectus (i.e., the regulatory “blueprint” document that details the fund’s objectives, fees, management style, and other operational features.)
Tip: You can find a mutual fund's prospectus on the fund company's website. The investment company will also mail you a copy of a fund prospectus, upon request or if you become a fund investor.
How Mutual Funds Work
When an investor places money in a mutual fund, it's combined with the investable assets of other fund investors.
Each share owned by a fund investor represents that investor’s share of the gains and losses generated by the fund. Ultimately, the fund shares purchased represents a portion of the stocks, bonds, or other investments owned by the fund managers.
Pricewise, fund assets are calculated as the net asset value (NAV) of the fund. The NAV represents the per-share performance of the fund, and is adjusted every day to offer transparency to the financial markets and the investors who steer money into those mutual funds.
Let’s say a mutual fund has $55 million invested in the financial markets and has $5 million sidelined in cash. That adds up to $60 million in fund assets. The mutual fund also has $10 million in liabilities, for a total fund value of $50 million
Let’s also say a mutual fund has five million shares outstanding. The price-per-share calculation is $50 million divided by $5 million, which translates into an NAV of $10 per-mutual fund share.
The fund’s NAV is adjusted at the end of every trading day. Once a mutual fund shareholder opts to purchase or redeem fund shares, the current NAV is the metric used to set the amount of the purchase or redemption.
Tip: Before investing in a mutual fund, take a good look at your own investment risk tolerance. In other words, how much investment risk can you tolerate before losing sleep at night?
Fees for Mutual Funds
Mutual fund companies charge a fee for their work managing the fund. The amount of the fee will depend on the complexity of the mutual fund's strategy and the resources it uses to achieve results. Higher performing funds may increase their fees year over year in an attempt to monetize recent performance. Due to the more complicated structure and administrative needs, mutual funds are generally more expensive than their ETF counterpart.
Types of Mutual Funds
There are multiple mutual fund categories, but by and large, mutual fund classes fall into four distinct categories, with each holding its own unique investment risks and rewards.
- Stock market funds. Funds that focus on stocks comprise a substantial subcategory of stocks. Stock funds are popular with capital appreciation investors (think younger, more aggressive-minded investors who are trying to accumulate wealth over the long haul.)
- Growth stock funds. Growth stock fund managers seek high appreciation via up-and-coming stocks that have the potential for better-than-average market gains.
- Dividend funds. These funds focus on stocks that pay regular dividends.
- Index funds. These stock market funds track a specific market index, like the Standard & Poor’s 500 (SP500) or the Russell 2000 Index (RTY).
- Sector funds. Stock sector funds target specific financial market sectors, like energy, banks/financials, or technology stocks.
- Bond funds. Bond funds, also known as fixed-income funds, invest in different bond classes like Treasury bills and bonds, corporate bonds, and municipal bonds. Bond funds are especially popular with capital preservation investors (think seniors either already in or approaching retirement and who likely can’t afford to lose money.)
- Money market funds. Like bond funds, money market funds offer lower risk relative to stock funds. Money market funds are limited, by law, to more secure and risk-averse short-term investment vehicles like federal, state and local government bonds, or select corporate bonds.
- Target date funds. These funds focus on a blend of stocks, bonds and other investment vehicles, with the fund strategy shifting as “life-cycle” age benchmarks, like 40, 50, 60-years of age. Lifecycle funds target investors who seek a long-term, even lifetime, investment plan, based upon specific timelines in their lives. As the fund investor ages, the fund’s strategy shifts to a more conservative investment tone as target date ages rise over time.
Mutual Funds vs. Stocks
While mutual funds and stocks are both broadly popular with the investing public, each investment vehicle is unique.
When you buy a stock, you are calling the shots and making the investment decision on your own. When you invest in a mutual fund, the fund management team makes the investment decisions for you.
- Stocks: Publicly-traded stocks represent individual shares in a company. As a stock owner, you are a direct owner of the company. For example, if you own 100 shares of XYZ company, you are a direct owner in that company, with all the rights that go with stock ownership, including shareholder voting privileges.
- Mutual Funds: are pooled assets from different securities, including stocks, bonds, commodities, and other select investments—with funds holding 100 or more stock positions. Mutual fund investors are steering money into an investment vehicle that bundles all the fund investor’s money together and invests that cash on their behalf.
Risk of Stocks vs. Mutual Funds
Risk is an important factor when deciding between stocks and mutual funds.
Stock owners are the holders of individual company stock, whereas mutual fund investors are indirectly exposed to the stock, which they share with other fund investors. That’s a big differentiator, risk-wise.
Consider an investor of Apple stock (AAPL). If Apple has a great quarter financially, and the stock price rises by 10%, the stock investor directly benefits from the rise in AAPL stock. That investor’s shares of Apple stock rises by 10%. Correspondingly, if Apple stock falls by 10% after a bad quarter, the investor’s stake in AAPL stock falls by 10%.
Mutual fund investors are owners of Apple stock, but they also spread the risk around by collectively owning shares of all other stocks in the fund. Consequently, with risk spread around, the fund investor doesn’t gain as much or lose as much, as Apple stock is just a small portion of the overall mutual funds holdings.
Advantages & Disadvantages of Mutual Funds
Like most investment vehicles, mutual funds have their benefits and costs.
Benefits of Mutual Funds
- Diversification. Studies show that investment diversification (i.e., spreading risk across multiple portfolio investments) helps protect investor assets while producing solid returns. By pooling assets together, mutual funds offer built-in protection if one or two fund investments decline in value.
- Capital gains features. Mutual funds experience price changes all the time. When the price of a fund investment rises, and the fund sells that security, that triggers a capital gain for the fund. At year-end, the fund will distribute capital gains to fundholders, minus any capital losses.
- Dividend payments a plus. Many stock mutual funds, especially income funds, generate dividend payments for fund shareholders. When a fund does earn dividend income, it distributes that dividend payment to fund shareholders.
Disadvantages of Mutual Funds
- Even with diversification built-in, you can still lose money. Mutual funds are not immune to investment losses. Mutual fund values decline on a regular basis, so there are no guarantees fund shareholders won’t lose money on their investments.
- Mutual fund fees can reduce portfolio returns. Mutual funds come with an assortment of management fees that can eat into returns. It’s not uncommon for mutual funds to charge annual fees of 1.5 percent of an investor’s fund assets – or more.
- Loose managerial practices. While most mutual fund managers are highly ethical and committed to stable fund management practices, some fund managers may engage in risk-laden behaviors like “churning” stocks to pump up trading fees, selling declining stocks too early to protect quarterly performance numbers, and not following fund strategy guidelines laid out in the fund prospectus.
How To Invest In Mutual Funds
Investing in mutual funds is a fairly straightforward process.
You can purchase shares of a fund through the mutual fund company (check the fund company website for specific directions) or from a stock brokerage company.
Simply fill out the fund purchase paperwork, fund the account, review the prospectus and fund contract, and research professional investment websites and apps to get a good grip on the fund and how it works.
When you choose to sell or “redeem” fund assets, know that you can do so any time by contacting the fund company or your broker. They’ll walk you through the process of selling fund shares and getting any payments due to you.
Tip: It's usually a good idea to talk to a fund company representative before investing in a mutual fund. That way you have even more information to make when deciding on the mutual fund that meets your unique needs.
Bottom Line
Mutual funds are a classic strategy for investors to achieve simple, inexpensive diversification. While they're not nearly as popular as they once were, they're still useful in some applications. Consult a financial professional to determine if they're right for you.
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