While it is technically possible to trade mutual funds for a living if you have a substantial amount to invest and are happy to employ a highly active trading strategy, mutual funds are not built for short-term investors. In fact, most mutual funds actively discourage short-term trading by implementing steep fees for early redemption or excessive trading.

However, you can generate a decent amount of annual income by investing in dividend- or interest-bearing funds. Of course, the amount of income you receive is a function of how much you invest, so those who have sizable bank accounts already are the most likely to be successful.

In truth, mutual funds are not the best choice when it comes to making a living through investing. Stocks and exchange-traded funds (ETFs) offer investment options that are much more suitable to active trading.

Mutual Funds: The Basics

Mutual funds have remained a popular option for investors because of the wide variety of funds available and the automatic diversification they offer. Mutual funds pool the investments of many shareholders and invest in various securities – such as stocks, bonds and short-term debt – according to the stated goals of the specific fund.

Funds that are more heavily invested in stocks or low-rated debt instruments are best suited for investors who are willing to take on a considerable amount of risk in exchange for the possibility of big gains. Alternatively, funds that only invest in highly rated corporate or government bonds are generally better for investors with low risk tolerance.

Mutual Fund Redemption

Unlike stocks or ETFs, mutual funds are not traded on the open market. Instead, investors must redeem shares directly with the fund, or through an authorized broker. The value of a mutual fund share – called its net asset value (NAV) – is calculated at the end of each trading day based on the total value of all the assets in the fund's portfolio. The share price does not fluctuate throughout the day like that of exchange-traded securities.

Because mutual fund shares cannot simply be bought and sold between investors, the fund itself must find the money to cover shareholder redemptions. Since mutual fund capital is typically wrapped up in the fund's portfolio, share redemption often requires the liquidation of assets.

How Short-Term Trading Affects Shareholders

When a mutual fund liquidates its holdings for any reason, it can generate a capital gains distribution for all shareholders. Because mutual funds are required to pass along all net gains to shareholders to avoid paying taxes on the income, any sale of assets that results in profit prompts a distribution. Every distribution raises the tax liability of all shareholders, not just the shareholder redeeming shares, making short-term mutual fund trading particularly burdensome to the remaining long-term investors.

In addition, excessive trading causes a mutual fund's expense ratio to increase because of the additional trading and administrative fees incurred. Short-term mutual fund trading increases the costs for buy-and-hold investors – mutual funds' key demographic – across the board.

Mutual Fund Early-Redemption Fees

The dangers of short-term mutual fund trading became apparent in 2003 when it was found that many investors were rapidly buying and selling shares to make quick profits, negatively impacting the returns of other shareholders.

To discourage the practice of short-term mutual fund trading and minimize its impact on long-term shareholders, many mutual funds now prohibit the liquidation of shares within a certain period. Many institutions closely monitor the number of round-trip transactions a shareholder makes – that is, any transaction in which an investor buys shares and then sells them again within a given number of days. At Fidelity, for example, an investor can be blocked from making any further trades within a set period if he is found to have executed multiple round-trip trades.

A Better Option: Dividend Funds

If you're set on investing in mutual funds, you can still generate annual income by investing in dividend funds and employing a buy-and-hold strategy commensurate with the security's intended purpose.

Dividend funds are mutual funds that invest in dividend-bearing stocks or interest-bearing debt instruments. Dividend equity funds only invest in stocks with proven track records of paying solid dividends every year. Similarly, dividend debt funds generate annual income from the guaranteed coupon payments carried by the bonds, notes or bills in their portfolios. Some balanced funds include both types of assets.

All dividend funds make at least one dividend distribution each year, but they may make more depending on when the underlying assets pay dividends or interest.

The Active Option: Stocks and ETFs

If you have a substantial amount to invest, it can be possible to make a living investing in dividend mutual funds. If you have that much discretionary capital on hand, however, you may be better served by diversifying your portfolio by investing in other securities. Stocks and ETFs are a much better choice than mutual funds for investors looking to make short-term gains; stocks and ETFs are designed to be bought and sold on any time frame, and they can be traded on the open market.

If you like the security of passively managed indexed mutual funds, for example, ETFs offer just as many indexed options but with lower expenses and fewer trading regulations. If you're looking to employ an active trading strategy but want to minimize risk, indexed ETFs can be an excellent option.

If you are more risk tolerant, trading stocks can generate substantial income, but with a considerable degree of risk. Some ETFs, such as leveraged or inverse products, also offer the potential for increased profits in exchange for a higher risk level. However, if you have enough capital to invest in mutual funds to the degree necessary to generate sufficient annual income, then you can probably afford to allocate a portion of those funds to a more high-risk/high-reward asset.

Conclusion

Using your investment portfolio to generate your yearly income is an enticing proposition. Actively trading mutual funds is unlikely to be your best bet, however. If you have a substantial amount to invest, you can potentially earn enough dividend income to meet your needs, but a diversified portfolio is likely to serve you better over the long term.

Discuss your specific investment goals with your financial advisor to see which products can provide short-term gains and which are best for long-term growth. By diversifying properly, you can use long-term investments to provide income in the future while using actively managed short-term assets to pay the bills now.

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